I’m reading a lot about how the VC model is dead, and the venture capital industry is drying up. Supposedly, this is caused by the lack of conventional exits and liquidity events, meaning the venture capital funds can’t return cash to their investors. While we are clearly going through a flat spot in IPOs, and the world of acquirers is reduced, I’m not sure that implies the industry is dead. I think it’s just going through a stretched out phase.
In the VC conferences, you see graphs of how much money is going into the funds, how much is being invested in early and late stage deals, how many deals are being done and how many exits are happening. Inside the fund meetings, there is always a lot of talk about Deal Flow: how many deals are we seeing, are we seeing the best deals or the dregs, how many are competitive deals where multiple funds are bidding up the price. And in the board rooms of our investments, we talk about cash flow and burn rates. Everywhere you look, the issue is the flow of money from one place to another, and accumulating in the chosen few winners. It’s all about Flow.
I want to talk about another abstract measure of the new venture business that I call Idea Flow. What is Idea Flow? Simplistically, it is the rate at which new ideas are being generated. And what is it a function of?
Well I think it is partly a function of population growth, and the number of fresh minds entering society from the bottom, for example the number of college graduates. Each young mind is taking a fresh look at the world and seeing it from a slightly newer perspective.
In addition, I think it is also a function of how far we have gone in digesting the last few major revolutions. For example, the concept of the Internet, and frictionless communication at negligible cost, this is a revolution that is clearly still happening. When there are major revolutions percolating through society that haven’t been fully exploited yet, then the Idea Flow rate is probably enhanced.
Finally, Idea Flow is a function of whether sufficient resources are available to gestate these ideas. Maybe this should be a slightly different concept, say Manifest Idea Flow. In other words, maybe just having an Idea isn’t enough. We also need to let it bloom or it’s meaningless.
I’m sure one can identify other contributors to the rate of Idea Flow. My point here is that basic Idea Flow is clearly still growing. The number of college graduates continues to rise each year, and the population continues to grow in all but the most extreme cases of deprivation. And we have experienced at least three major revolutions in the past few decades that are still playing themselves out. Information Technology (computers, memory, programming, AI), Biotechnology (genome mapping, molecular biochemistry, synthetic biology), Communication Technology (the Internet, email, texting, cellphones), these are three overlapping general categories of revolution in process.
I think Idea Flow is the bedrock of the Venture business. Without ideas, nothing can be created. You might as well buy Ma Bell and cash your dividend checks quarterly. The Venture Capital business starts with a couple of motivated entrepreneurs, a problem that needs solving and an Idea.
I believe that in this time of economic turmoil, where cash flow and economic growth and investment capital are down substantially, the bedrock of the Venture Capital business is still healthy. If anything the current turmoil makes aspects of our economy more ripe for disruption. If the old ways are broken, let’s try a new way.
A larger number of bright young minds are emerging each year, and the ground is fertile. And today it often takes less capital than ever before to manifest an idea.
So I’m bullish on the Venture Capital business right now. While others say it is dead or broken, I think it is likely to be even more fertile in the coming few years. Valuations are down and the potential for profit is therefore up. The markets are more vulnerable to disruption. And the public investor is always interested in an exciting story of the future realized. The IPO market in some form will reopen soon, perhaps even in 2009. And large companies will emerge from this downturn with their existing market approaches damaged, and needing new ways to continue growth. They will be acquiring again.
In the end, this business is about Idea Flow, and it’s still healthy.
Showing posts with label venture capital. Show all posts
Showing posts with label venture capital. Show all posts
Thursday, December 4, 2008
Sunday, October 14, 2007
Angel Valuations on Seed Rounds
In a recent IBF Panel on the topic of Angel and VC cooperation, I made the observation that I believe Angels should avoid valuing startups in priced rounds, and rather should invest using a convertible note. I said that nothing could screw up a follow-on VC investment more than an unrealistic early angel valuation.
I want to elaborate on that observation. First, I want to divide the startup world into two general categories: 1) startups that can reach their goals with a small infusion of seed capital within the reach of angel financing (i.e. less than $1M), and 2) startups that will ultimately require VC scale financing and are raising angel capital to eliminate some risk factor and improve their ultimate VC valuation. Frankly, this is an easy way to divide startups coming to angels. Is this deal a nearly self-sufficient business, or is it seeking seed capital before later going to the venture capital community.
In the first category, angels setting valuations are probably taking a defendable position. But frequently it isn’t clear at the outset whether the angel raise will be all the money the startup raises. So I think the convertible debt approach is still a good way to go. The note should have an automatic conversion privilege after a reasonable period of time, at a clear valuation.
However, more often it is better to assume the seed angel round is a precursor to a later VC round. In this case I strongly suggest that a convertible debt approach is the right way to go. Let me explain why, by showing the pitfalls of angels valuing a deal. Again there are two possible cases: A) setting the valuation too low, or B) setting the valuation too high.
Suppose the angel (or angel group) succeeds in convincing the entrepreneur to accept a lower valuation than a VC would demand, i.e. case A. Frankly, in my experience over the past few decades, this is very rare. Valuations tend to be set by the golden rule --- whoever has the gold sets the rules. VCs have more money in play, with the potential for multiple subsequent rounds, and will therefore be most likely to get a lower valuation. But for the sake of argument, assume that a low initial valuation is successfully negotiated by the angels. In that case, a follow-on VC round will likely see this as an invitation to lower their valuation proposal below what they might have otherwise offered. This will hurt the entrepreneur and the angel prorata. Even if the follow-on VC chooses a more “fair market” valuation, the entrepreneur will still be getting a worse deal. Either way you end up with a less happy entrepreneur, and maybe the angel is unhappy as well.
Now suppose the opposite happens, i.e. the entrepreneur manages to convince the angels to give him a high valuation, higher than he might get from a VC. In my experience, this is actually a fairly common experience. Seed rounds are often made by Friends and Family, and they are emotionally involved with the entrepreneur. They will accept a valuation set by their friend or “son” because “he knows more about this”. But again, for the sake of this analysis, assume the entrepreneur gets a higher than “fair market” valuation. When the follow-on VC comes to see the deal, they will quickly come to understand the valuations previously set and the expectations of the entrepreneur to up that valuation. They know to get this outon the table early. I can say that my VC fund sees this case a lot and it often stops a deal cold. Frequently, the entrepreneur has taken the high seed valuation to heart, and is insulted by a VC opinion that it is excessive. For the VC to proceed, they will have to offer a down round deal. Remember that VCs often are investing to a formula promised to their LPs, that mandates their seeking a certain percentage of ownership. An overly optimistic valuation in the seed round directly hurts both the entrepreneur and the seed angels.
So in summary, if there is even a chance that follow-on VC money will need to be raised, in my opinion, an angel-priced seed round is a lose-lose situation. The best outcome is the angels set a valuation very close to what the VC expects --- and that is exactly what a properly constructed convertible debt deal will deliver automatically.
In essence, a convertible debt deal is saying that the angels want to be in the same boat as follow-on investors, rather than starting out in opposition to, or second guessing them. I can clearly state that the VCs I have worked with will respect the greater risk that the seed capital took, and will accept a discount or warrant to reward that risk. They will appreciate the effort angels took to make the deal follow-on financing-friendly.
But a priced angel seed round is at best a breakeven exercise. Much of the time it will be to the disadvantage of the angel and it will almost always be to the disadvantage of the entrepreneur.
Convertible debt seed financing can be done with a timeout conversion at the angel’s option, with a time matched escalation of reward, and with interest and dividend privileges. In the end, the seed round is very exposed, and angels are investing monies they should never expect to get back. The lack of security for the loan is therefore relatively unimportant. And the conversion will be to a preferred round with all its carefully constructed advantages crafted by the VCs. In contrast, I often see priced seed rounds where the angels bought common stock. That opens the door to the VC constructing preferred terms that put the common stock class at a major disadvantage.
I will acknowledge that this advice is Bay Area centric, where there are many many venture capital funds. When the angel investment is coming in geographic areas with limited local VC financing, the value of this advice is lower.
As a general rule, ANY investment in a startup should be made so that follow-on financing is not inhibited. Valuation can be a big inhibitor to venture capitalists. And VCs will usually craft the best terms to protect their investment. It is better for angels to try to be under that same umbrella.
I want to elaborate on that observation. First, I want to divide the startup world into two general categories: 1) startups that can reach their goals with a small infusion of seed capital within the reach of angel financing (i.e. less than $1M), and 2) startups that will ultimately require VC scale financing and are raising angel capital to eliminate some risk factor and improve their ultimate VC valuation. Frankly, this is an easy way to divide startups coming to angels. Is this deal a nearly self-sufficient business, or is it seeking seed capital before later going to the venture capital community.
In the first category, angels setting valuations are probably taking a defendable position. But frequently it isn’t clear at the outset whether the angel raise will be all the money the startup raises. So I think the convertible debt approach is still a good way to go. The note should have an automatic conversion privilege after a reasonable period of time, at a clear valuation.
However, more often it is better to assume the seed angel round is a precursor to a later VC round. In this case I strongly suggest that a convertible debt approach is the right way to go. Let me explain why, by showing the pitfalls of angels valuing a deal. Again there are two possible cases: A) setting the valuation too low, or B) setting the valuation too high.
Suppose the angel (or angel group) succeeds in convincing the entrepreneur to accept a lower valuation than a VC would demand, i.e. case A. Frankly, in my experience over the past few decades, this is very rare. Valuations tend to be set by the golden rule --- whoever has the gold sets the rules. VCs have more money in play, with the potential for multiple subsequent rounds, and will therefore be most likely to get a lower valuation. But for the sake of argument, assume that a low initial valuation is successfully negotiated by the angels. In that case, a follow-on VC round will likely see this as an invitation to lower their valuation proposal below what they might have otherwise offered. This will hurt the entrepreneur and the angel prorata. Even if the follow-on VC chooses a more “fair market” valuation, the entrepreneur will still be getting a worse deal. Either way you end up with a less happy entrepreneur, and maybe the angel is unhappy as well.
Now suppose the opposite happens, i.e. the entrepreneur manages to convince the angels to give him a high valuation, higher than he might get from a VC. In my experience, this is actually a fairly common experience. Seed rounds are often made by Friends and Family, and they are emotionally involved with the entrepreneur. They will accept a valuation set by their friend or “son” because “he knows more about this”. But again, for the sake of this analysis, assume the entrepreneur gets a higher than “fair market” valuation. When the follow-on VC comes to see the deal, they will quickly come to understand the valuations previously set and the expectations of the entrepreneur to up that valuation. They know to get this outon the table early. I can say that my VC fund sees this case a lot and it often stops a deal cold. Frequently, the entrepreneur has taken the high seed valuation to heart, and is insulted by a VC opinion that it is excessive. For the VC to proceed, they will have to offer a down round deal. Remember that VCs often are investing to a formula promised to their LPs, that mandates their seeking a certain percentage of ownership. An overly optimistic valuation in the seed round directly hurts both the entrepreneur and the seed angels.
So in summary, if there is even a chance that follow-on VC money will need to be raised, in my opinion, an angel-priced seed round is a lose-lose situation. The best outcome is the angels set a valuation very close to what the VC expects --- and that is exactly what a properly constructed convertible debt deal will deliver automatically.
In essence, a convertible debt deal is saying that the angels want to be in the same boat as follow-on investors, rather than starting out in opposition to, or second guessing them. I can clearly state that the VCs I have worked with will respect the greater risk that the seed capital took, and will accept a discount or warrant to reward that risk. They will appreciate the effort angels took to make the deal follow-on financing-friendly.
But a priced angel seed round is at best a breakeven exercise. Much of the time it will be to the disadvantage of the angel and it will almost always be to the disadvantage of the entrepreneur.
Convertible debt seed financing can be done with a timeout conversion at the angel’s option, with a time matched escalation of reward, and with interest and dividend privileges. In the end, the seed round is very exposed, and angels are investing monies they should never expect to get back. The lack of security for the loan is therefore relatively unimportant. And the conversion will be to a preferred round with all its carefully constructed advantages crafted by the VCs. In contrast, I often see priced seed rounds where the angels bought common stock. That opens the door to the VC constructing preferred terms that put the common stock class at a major disadvantage.
I will acknowledge that this advice is Bay Area centric, where there are many many venture capital funds. When the angel investment is coming in geographic areas with limited local VC financing, the value of this advice is lower.
As a general rule, ANY investment in a startup should be made so that follow-on financing is not inhibited. Valuation can be a big inhibitor to venture capitalists. And VCs will usually craft the best terms to protect their investment. It is better for angels to try to be under that same umbrella.
Friday, July 27, 2007
Stating Intentions
As a serial entrepreneur for the past 3 decades, and now transitioning to an active VC, I'm in a good position to be looking at the VC community with fresh eyes. I'm forming some ideas on where I think the VC world is going, where it should go to remain relevant, and where it must go to adapt its return models to changing conditions. I hope to post some of these ideas here in the next few months, in my COPIOUS free time. Stay tuned.
In the meantime, I highly recommend the works of Nassim Nicholas Taleb, especially his most recent book, The Black Swan, The Impact of the Highly Improbable. VCs don't work in a predictable world, but they do work in a world where the improbable can be used to their benefit.
Easy
In the meantime, I highly recommend the works of Nassim Nicholas Taleb, especially his most recent book, The Black Swan, The Impact of the Highly Improbable. VCs don't work in a predictable world, but they do work in a world where the improbable can be used to their benefit.
Easy
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