2-Speed » VC

You Gotta Pay to Play . . . Or Not

Will — Sun, 07 Nov 2010 00:21:08 +0000

Last week, I wrote a post about the right of an investor to maintain their percentage ownership in a company through the pro rata rights provision often found in investment agreements. In that post, I referenced another provision that often crops up, pay-to-play. In its most basic form, the pay-to-play term causes an investor to lose certain antidilution protections if they don’t participate in later financings at a pro rata level. This loss can take a variety of forms. These range from a conversion of all the shares purchased by the investor in previous rounds from preferred to common (ouch!) to the loss of the right to participate in future rounds (a mild spanking).

I get why certain investors want this term in there – if a co-investor is not going to continue to invest in the company in subsequent rounds, why should they retain the rights and privileges of a holder of preferred stock? The same rights and privileges that investors investing their pro rata portion.

I understand the logic, but as an angel investor, I find little to like about the provision in virtually any form. If I, as an investor, supported the company early on and took on all the risks involved with an early investment, why should I ever lose the rights that came along with assuming that risk? That was the exchange at the time – money for some ownership and rights associated with the form of ownership. In my opinion, no future acts (legal, up-and-up ones, that is) should cause the retraction of rights I already have (superseding those rights is topic for another day).

When I invest in a company, I always reserve some money for the next round. Since I generally invest in startups, I consider what a reasonable jump up in the A round valuation might be and hold enough in reserve to maintain my pro rata share in the company through that round. If the A round is a large – dollar-wise – or there are rounds beyond the A round that I haven’t reserved for, I can easily find myself in the position of not having the funds needed to maintain my share. A pay-to-play provision, in these cases, would cause a draconian (yeah, I’m biased) removal of the rights I had already paid for through investment and risk. It just doesn’t make any sense.

I could whine or cry and say that such terms are unreasonable or unfair, but that would be stupid. In the end, I can only do one thing when I run across a pay-to-play provision in a term sheet, treat it as a big negative in my investment decision. I strictly stay away from deals that go as far as converting the preferred shares of those who don’t invest their pro rata percentage in future rounds to common. I treat as a negative, but don’t always walk away from deals with such provisions that are less onerous. Like I said, I understand why big, later stage investors want this term in the agreement. From my point of view, though, it punishes those who took the biggest risk when the company needed it most.

No Pro Rata Investment Rights?

Will — Fri, 29 Oct 2010 14:00:31 +0000

I passed on an investment this week because the terms of the deal didn’t include the right for investors in the current round to maintain their percentage ownership in the company, through additional investment, in future rounds. This is usually outlined in the term sheet, in legalese, as “Preemptive Rights,” “Right of First Refusal” or even “Right of First Offer.” Basically, such a right simply allows early investors to keep themselves from being diluted in future investment rounds. There is no free ride in this situation, of course, the investor must pay for their pro rata share at the next round’s price, just like everyone else. What was particularly troubling about the term sheet in question was that it was pretty clear that the lead investor excluded such rights from the terms in order to have the ability to flush out smaller, early investors in subsequent rounds of financing.

I’ve seen this before (although less frequently over time) and it boggles my mind. Yeah, if you have a boatload of little investments the cap table can be a bit complicated, but that’s just math. Generally speaking, smaller investors don’t have any strong voting rights, board seats or other forms of control so punting on them doesn’t improve the speed or operations of the company. It’s treating form well ahead of function.

So why explicitly exclude or inhibit any investor small or large from investing in your next round? Are you afraid that you might scare off a large, future investor who doesn’t want smaller investors involved financially? Think about it. Are there rational people who would take this position? If so, are these people you want to deal with? To me, the fact that existing investors want to invest more money to retain their ownership is a hugely positive signal indicating that the people who know a lot about the company have faith in its progress and opportunities for success. As an entrepreneur, don’t you want to encourage such behavior?

By not explicitly giving investors pro rata rights (keep in mind that this provision simply grants the investor the right, it’s not a requirement – I’ll write a post on “Pay-to-Play” term sheet weirdness soon), you not only create a problem in subsequent rounds of funding, but you also create a problem now, in the current round. If, as a potential investor, I fear that I may not be able to prevent my dilution in future rounds, how anxious a I going to be to get involved. I’m not. Thus, my exit from the deal this week.

As my long-time friend and corporate general counsel, Peter Johnson, always says, “it’s, at worst, giving them the sleeves of your vest.” “Them,” in this case, being the investors you want to have involved in the company now and, hopefully, in the future.

BTW, there are loads of resources on the web discussing term sheets from many points of view. I highly recommend you take a look at Brad Feld’s and Jason Mendelson’s term sheet series as a starting point.

Starting Up on a Shoestring

Will — Tue, 09 Mar 2010 00:30:19 +0000

A few weeks ago, I ran across a box full of photos I had taken a while back. Actually, they were color slides, which should give you some idea of how old they are. Many of them were of people, events and even documents (photos of documents? Don’t even ask, I can’t remember why) from my second startup (actually, my third, but it was the second one I founded). The company was originally named Qualogy Technology, but wiser minds prevailed and it was later changed to Viewlogic Systems.

Viewlogic/Qualogy was started by a gang of five (including me) out of Digital Equipment Corporation. We worked for a full year refining the idea, testing the market and looking for money before we finally got funded. We knocked on many doors, gave fewer presentations, discussed our plan with even fewer semi-interested VCs and seriously talked with only a handful of potential investors. We rewrote the business plan so many times, I think I had every word memorized. We changed our revenue model, sales model, marketing plan and development schedule, but never changed our fundamental idea. We stuck with it because we believed in what we were doing and always thought that we could convince someone with money that we and our ideas were worthy of investment.

After a full year of effort, we finally ~~beat someone into submission~~ found an investor who believed in us and our plan. What did that initial deal entail? A total investment of only $50K (see the checks above – $25K from two VCs). My friend Dave points out that it amounts to a little over $100K in today’s dollars – not much money. In retrospect, the term sheet was crappy – contingencies, ratchets, board control issues and so forth. But none of that really mattered, we were on our way. If we had to make some additional sacrifices to be successful, they were acceptable. It was all about having the opportunity to execute our dream.

In the end, it worked out pretty well for all concerned. While not an insane, Harvard Business Review case study, cover of the Wall Street Journal, blowout success, the company did pretty well. Viewlogic went public and then sold a few years later for a little over half a billion dollars. Before it sold, it employed about 750 people, had direct sales worldwide and roughly $170M in revenue.

These days, I see startups often putting in even a greater levels of effort and dedication than we did in forming Viewlogic. The focus and intensity of these young companies is really outstanding. Frequently, though, I see a do or die mentality when it comes to getting funded at relatively high levels. Entrepreneurs think of big funding events as milestones and measurements of success instead of just being part of the process of initially refining and focusing their ideas and later growing them. Funding shouldn’t be the goal, it should be an accelerant to help a company achieve its real goals.

With that in mind, young companies should always look for alternatives to the classic substantial (relatively speaking) first round. Can they self fund? Can they get to positive cash flow earlier? Can they do some custom projects (adaptations of the company’s product or service) for specific early adopters? Can they simply take less money to bridge them to more success and further funding down the road?

Don’t get me wrong, time is against almost every company. Getting things done faster is important and having money to spend makes that much easier. Starting on a shoestring, with less money, or even no money, doesn’t prevent success, though. And, sometimes, it can even enhance it. It’s worked before.

Does the Loudest Person You Hear Give the Best Advice?

Will — Tue, 05 Jan 2010 02:14:59 +0000

I’m fortunate that I get to work with many startups, both independently and with TechStars where I’m a mentor. There is no better way to learn than through teaching (learning is the most fun you can have, at least for a sustained period) and there are few better students than entrepreneurs. Good entrepreneurs always want to know why they should do something and not just what they should do. They test, challenge and refuse to take anything for granted; they’re highly motivated, smart and understand success is not about them as an individual, but about the team they can build; and they strive not only to make their first venture a success but also to become strong, solid leaders and managers that can build many great companies.

So, with all these qualities, it shocks me how often entrepreneurs choose a mentor because they’re the loudest guy in the room. You know that person, the one who likes to talk incessantly about all of his or her accomplishments and is quick to give advice on any and all subjects. The person who speaks before listening and has never had any failures. Yeah, that guy. Somehow, in the sponge-like desire that good entrepreneurs have to vacuum up every morsel of knowledge, they often attach themselves to the first person who sounds like they know anything. Unfortunately, that’s usually the one who brags the loudest.

So, here’s a simple three-step plan on how to avoid adopting Mr./Ms. Know-it-all as your savior:

First, recognize that you’re your only savior, everyone else is there merely to supply data, offer up some wisdom and, maybe, hold your hand.
Second, put yourself in a situation where you can get access to many mentors. You can do a load of legwork or sign up for a program like TechStars where mentorship (and a boat load of mentors to choose from) is the core of the program.
Finally, ask questions. Don’t grill a potential mentor, after all, you’re looking for free help. Instead, have a conversation and learn about what the person has actually done – how they’ve succeeded and how they’ve failed. Make sure they have real accomplishments and real failures (you learn more from failures than successes) and can communicate what they learned in a way that works for you. If hubris is what you hear, try somewhere else.

I’m no psychiatrist, but the loud braggart in the room is probably making up for something else (get your mind out of the gutter, I was referring to some business deficiency) or has had too much to drink. Either way, they do you no good. Be selective, find an adviser with both good advice based on things they’ve actually done plus the ability to communicate they way that works best for you. You’ll be much happier and likely, more successful yourself.

TechStars Comes to Boston

Will — Tue, 17 Feb 2009 15:39:47 +0000

Over the last few years, it has become increasingly difficult for Boston-based fledgling startups to get a leg up; to get, well . . . started. It’s mind boggling, really. There is so much talent and there are so many good ideas, it’s just been shocking to witness teams and ideas die on the vine. Some of this is about the availability of money, of course, with many New England VCs choosing to invest in larger or later stage deals, but more of it, in my opinion, has been about the environment. While there are some avenues for startup entrepreneurs to get help and advice, they are few and far between and often hard to get access to. Recently, Y Combinator, the last bastion of Boston-area startup aide chose to leave Cambridge for sunnier digs in the Bay Area.

The good news is that TechStars has been planning a move to Boston for the last six months and has just announced that will be in full operation this summer. TechStars has been hugely successful in Boulder. Its success has been because the program is based on mentorship. TechStars has a terrific group of mentors (yeah, including yours truly) that guide, teach, coach and help new entrepreneurs accelerate their ideas into real companies. And, of course, there’s money involved. TechStars invests a small amount of money to kick start each of the companies in the program.

Does it work? Hell yes! Last year, TechStars Boulder’s second year of operation, 393 teams applied for 10 slots. The high number of applications were driven by the success of the companies involved in the program – 12 of the 20 that have been through it have received follow-on funding and 2 of the companies from the first year (2007) have already been acquired. See more here.

TechStars Boston will be managed by Shawn Broderick and backed up by Boulder TechStars co-founders David Cohen and Brad Feld. A long list of Boston-area Mentors has already signed on to participate including, Colin Angle, Dan Bricklin, Don Dodge, Eran Egozy, Chris Heidelberger, Nabeel Hyatt, Warren Katz, John Landry, Rich Levandov, Bijan Sabet, Ronald Schmelzer, Bill Warner and me.

TechStars Boston will be located in Cambridge and is now open for applications for its ten summer 2009 slots. Applications are due by March 21, 2009.

Gun-Shy Venture Capital

Will — Wed, 14 Mar 2007 16:28:52 +0000

Shawn Broderick over at Myriad Missives has a great post titled The Loser’s Curse that’s definitely worth a read for anyone pitching their deal to VCs. Shawn refers to Fred Wilson’s post of the same name.

In his post, Shawn reflects on his failure to get venture capital for his last startup, Voxx. Voxx was similar to Wildfire, but utilized the modern communications infrastructure (read: the Internet) for its backbone. The use of the Internet not only changed the financial model in a positive way, but also opened up the opportunity to add loads of features previously unavailable when using POTS. In any event. Wildfire was apparently a moderate success from an investors point of view, but not a home run.

In attempting to fund Voxx, Shawn targeted Wildfire’s investors, among other applicable firms, knowing they were already familiar with the market and had been previously convinced that there was opportunity there. They seemed like the likely suspects. As it turns out, all of them turned him down. He now ponders whether Fred Wilson’s view that

“. . . when you fail at something so badly that you never want to try it again even if there are other and better ways to do it that may result in a better outcome.”

may have had something to do with it. This, of course, is referring to the idea that the VCs may have been gun-shy about getting back on the horse.

Shawn doesn’t know if Voxx had some fundamental flaws that kept it from obtaining funding, but is now considering the fact that The Loser’s Curse may have had something to do with it.

Interesting lesson.

Prepare and Be Prepared

Will — Fri, 23 Feb 2007 16:00:57 +0000

Brad Feld has a great post this week titled, Don’t Be Casual, in which he talks about a company in his portfolio that did a “casual” presentation to a VC firm, only to realize that the company’s idea of casual didn’t match the VC firm’s. In the end, “the meeting was a disaster.” Brad concludes his post with the message:

“. . . in all fundraising situations â€“ donâ€™t be casual. The first impression counts a huge amount and sets the tone. This is obvious, but even after doing hundreds of financings, I blew it this time.”

The post is a terrific lesson from many points of view and, while the comments seem to focus on the failure of the presentation itself, I believe that there are some higher-level lessons that can be drawn from this experience. Two, in particular, come to mind.

Generally speaking, if you blow your initial shot with VCs you’ve probably poisoned the well.

Many of my VC pals disagree with this point, but I’ve seen it time and again. Most VCs have a lot on their plates. If they’re not out fundraising, they’re looking at loads of deals or managing the ones already in their portfolio. Because they’re busy, the impression they take from their first meeting with you will likely be the one they fall back on the next time they have the opportunity to think about your company. If it was bad, it’s highly likely that their negative memory will make it easy for them to pass on the next meeting and ultimately, any deal with you. This remains true after you’ve gone back, having taken their advice on what would make your idea better, and refined both your idea and approach.
Make sure that you’ve gotten all the advice and made all the changes to maximize your potential value to your target VCs before you present to them. Find outside advisors and present to VCs that aren’t on your target list to get early feedback before you meet with the people you want to impress most.

Whether in fundraising situations or not, in business, always be the best dressed person at the ball.

Until you’re the person in charge, the one making the decision or a recognized luminary in your field, always make it a high priority to do what’s important to your audience better than they expect it to be done. That requires, of course, that you know what they expect; at least at a high level. Uncovering expectations is usually fairly easy – ask. If you can’t find out, do things in a way that would blow anyone away . . .

Treat the person your meeting like they’re the Queen of England – formality never hurts
Several readers of this blog feel differently about this, but I stand by it – stand up when you present. It shows respect for your material and the audience.
When presenting, be prepared to take the conversation in many directions. Check with the audience after the first few slides to see if your guess about best path is correct, if not, go to plan B, C or D.
Get feedback up front. State what you believe are the expectations for the meeting as the meeting starts. You may be surprised to find out that the person/people you are meeting with will tell you exactly what you need to do.
Don’t use jargon, acronyms and buzzwords to try to impress your audience unless you know for a fact that they’re in your audience’s lexicon.
When in Rome, dress like a Roman. Wearing cargo shorts and Chuck Taylors may fly in the office and maybe even with customers and partners, but if you dress that way in a meeting with a banker in New York, no good will come of it.

Whether your presenting to VCs, meeting with customers or presenting at a conference, prepare and be prepared. Knowing what to do ahead of time is always the best answer. If that’s not possible, and sometimes it’s not, then set yourself up to deal with as many contingencies as possible.

Technorati tags: presentations, fundraising, meetings

Getting Chastised by an Investor

Will — Mon, 18 Dec 2006 17:24:05 +0000

Several years ago, I was part of a team that did a slightly leveraged management buyout of a division of a larger company. The deal was a relatively straightforward acquisition of all the assets, licenses, rights and so forth of the division for about $55M. Roughly $35M came from a single VC fund. Another $15M was in bank debt and the final $5M came from a small fund that an investment bank had for such deals. At the close of the deal, the larger VC took a board seat, but the investment banker, at my urging, declined a seat at the table.

I was having lunch with the investment banker that did the deal (who is now the President and CEO of the investment bank) the other day. The conversation was cordial enough until he brought up the fact that he felt that he was never kept in the loop about what was going on inside the company and was constantly surprised - mostly negatively – with news from and about the company. He reminded me that at one point, the bank had threatened to pull the company’s loan. Something that he did not learn about until very late in the process.

Needless to say, I was exceedingly embarrassed. As hypocritical as it sounds from this situation, I pride myself in my active communication with all parties involved, regardless of the level of their involvement. It’s not even like the guy was an asshole or anything. In fact, he’s a terrific guy who would work to help me deal with any issues in a calm and straightforward manner . . . if given the chance. His advice was always good and, even more important, it was given well. Gulp! I screwed up. Further, I’m sure I’ve done this type of thing many times, too. He’s just the first guy who thought it was worthwhile to say something about it.

So, what did I do wrong. After a few days of reflection, it was clear that I made several mistakes.

My belief that I’m great communicator prevented me from seeing that I’m not. Well, not always anyway. Damn the ego!
I treated investors sitting at the table (the Board table, that is), different from investors less actively involved.
I forgot that my pool of mentors and advisors extended beyond the people I interact with on a day-to-day basis.
Over time, my ignorance of the problem became a permanent mental block as we took the company public, eventually selling it, and everyone made money. Success clouds the recognition and memory of failure.

Doh! It’s really ~~painful~~ ~~rewarding~~ ~~upsetting~~ great to have a good kick in the ass once in a while to remind me that I still don’t really know anything.

Technorati tags: investors, communication

Valuation Tipping Points

Will — Tue, 14 Nov 2006 12:53:19 +0000

As a somewhat active angel investor, I’ve come to the conclusion that too many startups are looking for money too early in their development these days. Perhaps this has always been the case, but it’s become more obvious to me in the last 6-12 months. In the last month, alone, I have seen three deals that each involved teams that wanted to sit back in there current big-company jobs while producing no more than a PowerPoint presentation. No skin in the game, no special effort, nothing proven. They have taken little-to-no risk and applied relatively minimal effort, so why should an investor?

I’m a great believer that time is almost always the biggest competitor to any enterprise, but I also believe that there are certain milestones that need to be achieved to show that a startup is investment worthy (meaning that the company has a reasonable shot at success). Generally speaking, the market does a good job regulating this. For the most part, startups that have not made enough progress get crappy valuations (where crappy includes not getting noticed by investors) and startups that have made the appropriate progress get reasonable or even good valuations. I refer to the difference between these two states as the valuation tipping point.

The interesting thing about the valuation tipping point is that there is no fixed criteria or plan of attack for reaching it. Often, the tipping point is defined by the industry you’re in or by how you reach your customers. Good friend and VC Brad Feld posted a while back on the fact that in a Web 2.0 company, the first 25,000 users are irrelevant. If that’s true, then the tipping point for a Web 2.0 startup is going to be achieving more than 25,000 users. Other companies, markets and industries will have different measures for the achievement of the tipping point - usually involving one or more of the following:

Achieving some level of revenue
Selling to a certain number of customers
Signing up one or more partners
Reaching positive cash flow
Demonstration of the underlying technology
Establishing a sales channel
You get the idea . . .

Sometimes a valuation tipping point will be as simple as getting an OK from the gorilla in your market that it’s cool to play in their playground. If, for example, you’re using eBay’s API to build a business that doesn’t help eBay, investors will be interested in a getting some confirmation from eBay that they won’t 1) change the API to screw you or, 2) won’t drop a cease and desist letter in your inbox. Before you get such a confirmation – bad valuation, after you get it - good valuation.

Recently, I looked at a deal that had three difficult hurdles to clear in order to even be on a path to success. They were the development of the underlying technology; a relationship with a data provider required for their service; and a relationship with the distribution network. They had nailed two of the three, but the third remained a huge potential barrier to success. The company has yet to get any investors to make a move and until they deal with their remaining barrier, the company will probably not get funding. After they take care of the issue, though, I believe that this startup will get a great valuation.

Do you know what your valuation tipping point is? It’s probably going to fall in one of two general categories:

It’s going to be a big hurdle which you can’t control by simply managing your day-to-day business. Most often, this involves a business decision that has to be made by another party and is not in your direct control.
Or, it will require that you attain a level of business (measured by users, revenue, profit, etc) to prove market acceptance or competitive viability. Often, that requires you to successfully deliver in multiple areas of your business.

Before you look for any investment you should make sure that you understand where your tipping point is and how you will overcome the barriers that make it up. Even better, to maximize your valuation, get to the tipping point before you even look for an investment.

Note: the most important valuation tipping point happens at your first round of investment, but it is not the only valuation tipping point. Each subsequent financial round requires an analysis of the tipping points in your business and how getting to those points will impact the valuation you get.

Technorati tags: angel investing, valuation, tipping point

Venture Capital Insights

Will — Tue, 07 Nov 2006 00:11:37 +0000

Dharmesh Shah over on OnStartups has a terrific post titled 9 Pithy Insights on Venture Capital. The post covers many of the key points that should be in the new entrepreneur’s handbook on getting venture capital. I found myself nodding my head as I read each one.

I’d add to the list (in a way that’s not nearly as pithy or concise as Dharmesh) that it is very important to realize that all VC firms are NOT created equal and the dynamics that those inequalities bring will, most likely, have a big impact on how your company gets it’s current round of capital as well as each subsequent round. While I’m not a venture capitalist, my view from the outside, having been the beneficiary of more investment rounds than I can count, is that there are at least two tiers of venture capital firms. There may be more than two, but for the sake of simplicity from the entrepreneur’s standpoint, tier 2 through tier n appear to be regarded similarly and, generally speaking, act similarly. I’m not counting angels or angel funds here. The former are almost always subordinated by venture capital firms and the latter act more like nth-tier VCs than they do like angels.

Top-tier funds are generally larger (in terms of money being managed and number of partners), more established, have more experienced partners on the whole and are better known in their areas of focus. This is not to say that top-tier funds aren’t sometimes smaller or that second-tier funds don’t have uber-experienced partners, but the generalization does fit most often (as generalizations should).

Here are some actions that are indicative of a top-tier firm:

They do larger initial deals
More partners and more money means that they do more deals
A relatively high percentage of their investments are in later rounds
They frequently do M&A type investments along with pure venture deals
They don’t usually mention the 2nd-tier funds they have worked with
While they’ll jump quickly for certain investments, deals on the fringe of their expertise or that are otherwise not a slam dunk may take a while to close

Here are some actions that are indicative of 2nd-tier firms:

They look to do highly-leveraged, smaller initial deals
They’ll often move faster than larger firms to get a deal they find exciting
Since they are often squeezed out of popular deals, they tend to jump at the opportunity to get into or even lead a deal they think will be desirable by top-tier firms.
They almost always mention the top-tier funds they have worked with
They are often more likely to nurture a deal that they feel has promise, although resource limitations can make this difficult for them

None of this is shocking, of course, and if you’ve shopped a deal around before, you’ve probably already drawn similar conclusions. In my experience, though, there is an added point that appears to be virtually unspoken: top-tier and 2nd-tier VCs often don’t play well together. Why does this matter? Because many venture deals involve investment from both types of firms and if an entrepreneur seeking funding isn’t aware of the potential pitfalls, they may find themselves wasting loads of extra time capitalizing the company instead of running it or potentially giving up more equity than is necessary.

As I see it, the problem manifests itself in two ways:

Startups that do their A-rounds with 2nd-tier VCs often have trouble bringing in top-tier VCs in subsequent rounds. Top-tier VCs like being in control and, therefore, don’t like being subordinated to the smaller A-round investors. This means that later rounds of funding may have to rely on 2nd-tier VCs that are generally not as deep-pocketed as their larger brethren.
Top-tier VCs often want to be the lead in a round that has both top-tier and 2nd-tier investors. In my experience, this can result in a large amount of time and money spent on negotiating terms with the lawyers. Because of the relationship, this can obviously happen when the 2nd-tier firm takes the lead as well.

This is not a science, of course, and your mileage may vary. There are, I’m sure, many venture capital firms, both large and small that work together seamlessly. However, having witnessed the problems of mixing oil and water many times and having heard about it from others plenty more, I believe that such problems are far from rare. In the end, these factors only come into play when you have funding choices which many startups don’t have. Most startups will end up taking money from the best (or only) available source. This is absolutely the right thing to do, regardless of the factors mentioned here. If you have a choice, though, these factors should be considered. Even if you don’t, they’re good to know ahead of time.

Technorati tags: startups, venture capital, funding, VCs