I want to begin to tackle my original topic of interest, i.e. where is the VC business heading in the coming decades. I thought I'd start out be defining the tasks a VC performs, i.e. what skills make one VC better than another. The fact is there probably is only one ultimate measure of a VC that counts --- return on invested capital. I’m not trying to dispute that. But what are the characteristics of a VC that will lead to a good return in the end?
I’m going to organize this somewhat chronologically through the process. And I’m focusing on skills and tasks along the way. Here’s the outline:
1. Finding Deals
2. Evaluating and Picking Deals
3. Executing an Investment
4. Managing and Growing the Deal After Investment
5. Finding a Successful Exit
One can assume that focus, intelligence, integrity, fairness, responsibility, and good communication skills --- these are all valuable and assumed across the board. Finally, I have no gender biases and will use the male gender for simplicity. A female VC can certainly be as good or better than any male VC.
In this first posting on this thread, I’m going to address just those Step 1 skills. Other steps will follow in succeeding postings.
Step 1: Finding Deals
For a venture fund to be successful, it must have a rich deal flow. Garbage in, garbage out… as the saying goes. And every deal presents a different mix of characteristics. The fund needs to see lots of possible deals, ideally all with the fundamentals in order: solid management, strong technology, addressing big markets and with barriers to entry. There is no such thing as a venture fund that invests in every deal presented to it. The venture business is a sifting business. The better the selection, the better the investments that will result.
Therefore a successful VC must either a) get a lot of deals referred to him by colleagues in the field or past associates, OR b) get out there, see a lot of deals and maintain a high profile.
In subcategory a) are those VCs who have a great deal flow coming to them naturally by referrals --- I believe these are rare birds. They are usually extremely successful VCs from the most prestigious funds. We all know a half dozen names of superstars in the field. The best deals frequently come directly to them. That is a result of their success up to now, not the cause of it. Sitting back and waiting for the deals to come to you isn’t something to emulate. I do acknowledge that some superstars are surrounded by a great support staff who often go out and do the legwork for them. But I’m talking here about how you become a superstar, not how you act after you are one.
The second subcategory b) “get-out-there” path favors a personality that is friendly, helpful and engaging. It definitely does not favor arrogance or reserve. Entrepreneurs are more likely to want to work with VCs who are approachable and mentoring. Unfortunately, the VC community often draws its players from the most successful leaders in business and these are frequently very egotistical people. In my opinion, this is counter-productive to getting a good deal flow.
Ironically, it takes a lot of self-confidence to invest millions of dollars in a deal where the team is young and imperfect, the technology is new and unproven, the market doesn't even know it's a market and the incumbents in the market are big and powerful. That favors aggression, competitiveness, and single-minded focus in a VC. In other words, it naturally pulls a VC's personality away from what I think are key skills to this stage in the investment process.
Nevertheless, I believe the key skills for a VC are to be visible, approachable, helpful and mentoring. It is possible to hold these skills and still be self-confident and focused. As an aside, I think this also favors former entrepreneur VCs over professional MBA VCs. A VC can be most helpful from a position of shared experience. Entrepreneurs will appreciate that experience.
So I would argue the best VCs are confident, polite guys, who relate to the entrepreneurs out there, who do lots of panels and presentations, are accessible, listen well, and contribute more than just occasional funding but also advice to entrepreneurs. A VC who does all these things, and does them well, will see more and better deals.
Summary Skills for Step 1: Accessible, open, helpful, visible, mentoring, confidence without arrogance
(To be continued)
Sunday, December 9, 2007
Saturday, December 1, 2007
Angel Deal Types
I’m involved with three different angel groups, and often guest at the meetings or screenings of two others. I see a lot of deals in the screening process for these groups. It seems these deals fall into four general categories:
1. Low Capital Requirement Deals. Deals that don’t need a traditional, venture capital-sized investment to get to cash-flow breakeven. These are capital-efficient deals that can get to revenue early, and boot-strap themselves through the growth stage. In today’s web x.0 world, I think these deals are more common than ever (as I have blogged previously). And I think they benefit from a particular kind of angel investor, i.e. one who has a more active hands-on approach and plans to mentor the deal and team more. These deals are unlikely to raise or even need follow-on VC investment and get a more experienced and connected board later. The mentors they pick up in the angel round may end up being the guys they use as advisors throughout the history of the company. These are not “fire-and-forget” angel deals. And they may make more sense as simple priced, preferred stock deals, rather than convertible debt deals that I have advocated in previous postings.
2. Seed Deals. Deals that need seed capital to address some early risk factors prior to seeking their first formal venture capital round. The idea is to reduce those risks so they can get a better valuation from their first VC round and experience less net dilution. Frequently, a valuation inflection point is only an angel round of seed investment away. It may be to build a proof-of-concept model, or launch a beta test, or stabilize and add to a thin development team. I think deals in this category are more common in areas like the Bay Area where there is abundant VC funding. And this is the kind of deal where I think a convertible debt deal with a discount or warrant, and an escalator for delay in conversion makes the most sense.
3. Failed To Raise VC Money Deals. Deals that have tried and failed to raise their first funding round from conventional VCs and are “moving down the food chain” to Angel Groups. These deals normally have very tenacious founding teams who aren’t taking no for an answer. Often they revise their pitch to reduce their capital needs so as to appear more angel-friendly. In some cases this may make sense. If they were naïve at first and underestimated the impact of their risk factors on the VCs, they may have come up dry. They may benefit from converting to category 2 Seed Deals described above. The logic is “Raise less money, address your weak points, and then go back to the VCs.” Unfortunately, I see a lot of deals in the angel world that aren’t like this. They are simply failed venture deals. Frequently, they are failed VC deals because of team problems, or IP issues. They still have high capital requirements and are inappropriate for angel investment. There is an irrational aspect to starting a company, and slightly irrational entrepreneurs can assume that a lot of turn-downs simply means the VCs don’t get it. And angels may not look as deeply or be as experienced investors. A good story may snag an angel where it wouldn’t convince a VC.
4. “Bridge” Deals. Deals where a company has already successfully raised a previous round or rounds of money, has burned through that money and the existing investors are now disenchanted and no longer interested in follow-on financing. The entrepreneurs are trying to repackage the deal, spin it a different way, “put lipstick on the pig” and sell it to the angels. The entrepreneurs in this case may be reasoning that angel groups are less likely to come at the deal with knives, i.e. to force a down round. Angels may be more gullible. The entrepreneurs may position this as an opportunistic chance for the angels to bridge the company to its next “inevitable” venture round. As I have said in a recent posting, this is very dangerous ground for angels to be investing in. Failed startups that are back looking for new money from angels in a distressed condition, will very likely “experience the knives” eventually. The capital capacity of angels is unlikely to be able to fix what ails that kind of company. Angels who play in this category had better be experienced bottom-feeders. This is a special and dangerous world.
No doubt there are other more specialized categories, and admittedly, some deals won’t fit neatly into one of the above categories, and may have aspects of more than one.
An important question for angels to address when seeing a new deal is which category does this deal fits into. In my humble opinion, angels and angel groups are best advised to invest in the first two categories, i.e. deals that are clearly within the capital reach of angel money (category 1), or deals where the angels are effectively becoming cofounders and helping position the company for its highly likely first institutional round under fair economic terms (category 2). I believe angels should avoid deals that have been extensively and unsuccessfully shopped to VCs (category 3), unless they can see a way to turn the deal into a category 2 deal. And I believe angels should avoid deals (category 4) where VC’s have already played and are now absent. “There be tygers…”
Entrepreneurs are just a bit irrational --- they have to be to start a company from scratch. I know. I’ve been there multiple times. They will say what they need to to get funded. They will alter their story to make it seem angel-friendly.
Angels and angel groups are usually seen as the farthest out-there on the money tree. They will tend to naturally see the earliest and rawest deals, or the most desperate deals. It is best for angels to first try to separate the deals they see into early vs desperate piles. Highly motivated entrepreneurs are great; desperate, back-against-the-wall entrepreneurs can be a lot of trouble. Then focus on whether you want to back a deal with a few other angels, or as a precursor to bigger investment by VCs.
My two cents…
Thursday, November 15, 2007
More on Convertible Notes
I posted a couple of weeks ago on convertible notes and how I thought Angels were better off using them (Angel Valuations in Seed Rounds). I’ve realized that there were some inherent assumptions in that posting that I want to clarify. I’m prompted by a talk I saw yesterday where an experienced angel was discussing some bad outcomes he had had with bridge loans.
So I want to clarify. My posting was advocating the use of convertible notes in early stage deals, i.e. where the angel group (or individual angel) is providing seed funds or bridging to a first venture round. In those cases, I definitely think the convertible loan route is usually the way to go. There may be specialized exceptions, but that is a general rule.
The bad loans I was hearing about were much later stage loans. In one case, the loan was to a struggling company that already had taken in three rounds of money (i.e. had almost exhausted a Series C). They were running out of cash, and went to angels for a bridge. Presumably, their earlier investors were tapped out or disenchanted, but either way, the earlier investments were completely exposed. This is a “distressed company” bridge loan. Sometimes it is called a “pier” loan, i.e. a bridge to an uncertain destination.
I frankly believe this is an area where angels simply should not fly. Almost by definition, if the company can interest a Series D investor, there will be a major devaluation coming, and when that happens everybody is going to get a haircut. That kind of situation will even tend to select for a VC who is “bottom feeding”, and they are even more likely to not respect shallow-pocketed angels, even if the angel money is the most recent money in the deal.
It is a given that a seed-stage startup is distressed --- they have little beside an idea and sweat equity. But there is little to lose --- the valuation is hypothetical and somewhat arbitrary at first. The seed investors are in the same boat as the entrepreneurs, when facing the first institutional investors in a Series A. The Series A money doesn’t want to disincentivize the entrepreneurs, and the seed angels can shelter somewhat under that umbrella.
But later stage deals are cases where valuations have already been made, money invested, and positions have to be defended. These are circumstances where angels are ill-equipped to fight. This kind of defensive battle favors deep pockets and additional firepower. Most angels or angel groups are not good at deals that require repeated reinvestment. VCs know this and the knives will come out.
So I believe that in most seed and early stage deals, angels are well-advised to use a time-limited, escalating-return, convertible note instrument in their investing. And I further believe that angels should avoid getting involved in later stage bridge or “pier” loans in companies that have already been valued and are now likely to be revalued. In that case, I think angels should try to make any investment as a piggy-back on the new VC money, if they can get it, and not get out in front of that VC money. They will get run over.
So I want to clarify. My posting was advocating the use of convertible notes in early stage deals, i.e. where the angel group (or individual angel) is providing seed funds or bridging to a first venture round. In those cases, I definitely think the convertible loan route is usually the way to go. There may be specialized exceptions, but that is a general rule.
The bad loans I was hearing about were much later stage loans. In one case, the loan was to a struggling company that already had taken in three rounds of money (i.e. had almost exhausted a Series C). They were running out of cash, and went to angels for a bridge. Presumably, their earlier investors were tapped out or disenchanted, but either way, the earlier investments were completely exposed. This is a “distressed company” bridge loan. Sometimes it is called a “pier” loan, i.e. a bridge to an uncertain destination.
I frankly believe this is an area where angels simply should not fly. Almost by definition, if the company can interest a Series D investor, there will be a major devaluation coming, and when that happens everybody is going to get a haircut. That kind of situation will even tend to select for a VC who is “bottom feeding”, and they are even more likely to not respect shallow-pocketed angels, even if the angel money is the most recent money in the deal.
It is a given that a seed-stage startup is distressed --- they have little beside an idea and sweat equity. But there is little to lose --- the valuation is hypothetical and somewhat arbitrary at first. The seed investors are in the same boat as the entrepreneurs, when facing the first institutional investors in a Series A. The Series A money doesn’t want to disincentivize the entrepreneurs, and the seed angels can shelter somewhat under that umbrella.
But later stage deals are cases where valuations have already been made, money invested, and positions have to be defended. These are circumstances where angels are ill-equipped to fight. This kind of defensive battle favors deep pockets and additional firepower. Most angels or angel groups are not good at deals that require repeated reinvestment. VCs know this and the knives will come out.
So I believe that in most seed and early stage deals, angels are well-advised to use a time-limited, escalating-return, convertible note instrument in their investing. And I further believe that angels should avoid getting involved in later stage bridge or “pier” loans in companies that have already been valued and are now likely to be revalued. In that case, I think angels should try to make any investment as a piggy-back on the new VC money, if they can get it, and not get out in front of that VC money. They will get run over.
Friday, November 2, 2007
An Alternate Investment Philosophy, Finding the Disruptive Deals
As I have mentioned in an earlier posting, I believe the nature and scale of many startup deals is changing. While VC funds are generally getting larger and the amount they need to invest in every deal is also getting larger, startup deals are generally requiring less capital to get off the ground. There is a disconnect here. I’ve noted that this is opening a window for angels. And I’ve just blogged that it may not all be good for entrepreneurs.
The Holy Grail for VCs is the big, hairy, disruptive deal --- an idea that completely upsets the playing field in a market area and allows for huge scaling and a big win for the investor. Think Skype, or Google (the ad company). How do you find “disruptive” deals, i.e. ones that can create 100x returns?
I am inspired by comments made by Nassim Nicholas Taleb in his most recent book, The Black Swan, The Impact of the Highly Improbable. He describes an investment philosophy where 80% of your capital is in lower risk, more conventional investments, and 20% is in smaller high risk investments --- trying to expose yourself to lots of possible positive Black Swans.
Now admittedly, he is talking about an overall investment philosophy from the perspective of a fund manager in NYC. But there is the kernel of a good advice here, I believe.
I’m suggesting that a VC fund should consider such an investment philosophy. The VC fund should set aside a specific seed-fund that is used explicitly to look for positive Black Swans. This seed-fund should invest in earlier stage or riskier investments, or to simply play hunches. The partner group should loosen their normal criteria when evaluating these deals. They should focus more on how disruptive the idea is. There may even be an opportunity to allow an individual partner to play a personal hunch. The decision can be made by just that partner, subject only to the outright veto by one of the other partners. I am proposing that that partner does not necessarily have to convince everyone to agree with their vision. And critically, in all cases, such a seed investment would have to be made with the expressed provision, at the fund’s option, to subsequently invest more, up to some limit.
Some Justification and Comments:
It is increasingly apparent that IT deals often need less capital to get off the ground. Also entrepreneurs are growing wiser about delaying a traditionally-scaled venture round until they have more traction. And angels are increasingly filling that gap. Early stage VC funds are prone to being "jumped" by deals that go from an angel round to a larger VC round.
Setting aside an explicit subsidiary seed fund and committing to try to invest it in more, smaller, more speculative deals will focus a VC’s attention on playing some educated hunches. I believe that the rational consensus-oriented approach VC funds currently rely on almost exclusively, leads to a more mundane set of moderate return deals and misses on the individual investment hunches of each investment professional.
One can assume the fund will see a larger attrition in these smaller seed deals, but even if they all fail the total amount lost would collectively only be equal to one or two failed conventional deals. On the up side, the fund may get a large piece of a more disruptive deal by grabbing a piece earlier. The result would likely more than offset these speculative losses, and maybe even “make the fund”.
Such deals would require some time commitment to mentor. Such mentoring and early support will build the fund’s reputation in the entrepreneurial community. More early deals may also come the fund’s way. It can be synergistic to their investment goals. And they learn by immersing themselves in some leading (bleeding?) edge deals that they otherwise would miss. The selection criteria for these deals might include a requirement that the team is clearly identified as “coachable”.
To put it simply, making seed investments from an explicit seed fund allows the fund to bet on more horses than they otherwise would and increases the chance that they’ll get a big winner.
This does not necessarily represent a relaxation of the fund’s investment decision standards. I believe that some of the best returning, most disruptive deals a VC may see do not lend themselves to classical due diligence and risk minimization. Sometimes it is a matter of connecting the right idea to the right people that unlocks big value. Doing more seed deals will allow the fund to possibly unlock more of these big opportunities.
Some deals are execution deals while some deals are big idea deals. I believe the current VC process tends to favor the former, but the big, hairy, disruptive deals with >10x return potential are more likely in the later category. Big idea deals don’t lend themselves to classical diligence.
Finally I want to acknowledge that Charles River Ventures has prominently taken a position that is similar to this idea. I’ve seen it stated that they are addressing the smaller deal demand issue with this plan. My point here is there may also be a greater yield in big idea, disruptive deals by making more smaller investments.
Tuesday, October 30, 2007
“Worth What You Pay For It?” Musings on Entrepreneurism without a clear economic goal…
A couple of postings back, I noted on how web startups could get going on much less invested capital, and how startup investing had to adapt. Well here’s another way of looking at it, that isn’t so sanguine.
I’m stimulated by a posting I read recently by Paul Graham of y-Combinator fame (http://www.paulgraham.com/webstartups.html). He is hitting on many of the same points, i.e. that startups can be launched much more efficiently now, that capital needs are lower and time to market is shorter. I couldn’t agree more. He also makes a number of sweeping generalizations that my 7th grade teacher would have nailed me for. I don’t buy the whole message.
But my point here is to say it isn’t all good. Along with a blossoming of inexpensive web startups, there are also a lot of cool apps with hopelessly non-existent business models … if we build it they will come. There seems to be a growing divide between things you can do that will have a big impact on the world, and things you can do that will have a large economic return on investment. I often find myself in a presentation on a new startup idea, where I could definitely use the product, but can’t figure out how they will make a business out of it. I can see clear value in it, but no way to extract that value.
It feels like we are in an Oklahoma Land Rush world. A couple of major paradigm-shifting changes have occurred (the Internet, the cellphone, ubiquitous computers, mapping the Human Genome…), and now we have this whole generation of bright people rushing across the newly opened landscape, seeking homesteading sites to stake a claim on. Some people are doing a good job finding economically valuable homestead sites. Others are just trying to sell wagons and provisions to the incoming flood of homesteaders. Yet others are trying to stake out beautiful view lots that won’t be economically valuable but give a great view (and someday may therefore become valuable). And others are simply enjoying the run in the countryside, and are admiring their beautiful running form.
Many startups I see today are simply not venture investible. That doesn’t make them bad, just not good vehicles for VCs to invest in and get a return from. VCs have to return money to their investors. Hence they can only invest in a subset of the new ideas brewing out there, i.e. the ones that have the potential for a steep increase in economic value over a short period of time. And not likely to help the entrepreneur put food on the table.
But what happens if you can start a company with practically no money and no hassle pitching angels. My fear is that entrepreneurs will expend an enormous amount of effort launching a startup that can never become self sustaining. They have become enamored with their own idea and it’s novelty, and haven’t tested it outside of their narrow circle. And because they haven’t had to go out there and convince others that it’s a good idea --- and pitch the idea over and over again to investors --- adapt the idea to what seems to stick to the wall --- they will ultimately be wasting their time. It may be very worthwhile meaningful work, which makes a difference and draws huge traffic and changes the flow of homesteaders across the prairie, but doesn’t end up making the entrepreneur or their investors any return. In the end, it’s possible the entrepreneur will look back on these years as wasted --- benefiting others but not themselves.
What’s happening on the web is frequently cultural, and not necessarily economic. Great revolutionary businesses are being created, and great cultural changes are happening, but they don’t always overlap. And the test of a good idea is not that it is neat, or that it can be implemented simply and elegantly, or that it can draw many other’s curiosity and interest. The test of a good idea is the value others will place on it, and a good proxy for that value is the money they will pay for it. A good predictor of that value is whether others find it investible, be they angels or VCs.
So I think it is a good thing for entrepreneurs to have to pitch their ideas and convince others to put a value on it. I found in my own entrepreneurial career that my business models and even my technical ideas benefited from being pitched and explained to others. They became more focused and distinct. I recall A-HA moments that happened in front of prospective investors.
I worry about a world where doing things, making a big impact, affecting our culture in a big way, has such a very low cost of implementation. And even pitching some small investors isn’t necessary. I think it is bad even for the entrepreneurs who might seemingly benefit from it.
I’m stimulated by a posting I read recently by Paul Graham of y-Combinator fame (http://www.paulgraham.com/webstartups.html). He is hitting on many of the same points, i.e. that startups can be launched much more efficiently now, that capital needs are lower and time to market is shorter. I couldn’t agree more. He also makes a number of sweeping generalizations that my 7th grade teacher would have nailed me for. I don’t buy the whole message.
But my point here is to say it isn’t all good. Along with a blossoming of inexpensive web startups, there are also a lot of cool apps with hopelessly non-existent business models … if we build it they will come. There seems to be a growing divide between things you can do that will have a big impact on the world, and things you can do that will have a large economic return on investment. I often find myself in a presentation on a new startup idea, where I could definitely use the product, but can’t figure out how they will make a business out of it. I can see clear value in it, but no way to extract that value.
It feels like we are in an Oklahoma Land Rush world. A couple of major paradigm-shifting changes have occurred (the Internet, the cellphone, ubiquitous computers, mapping the Human Genome…), and now we have this whole generation of bright people rushing across the newly opened landscape, seeking homesteading sites to stake a claim on. Some people are doing a good job finding economically valuable homestead sites. Others are just trying to sell wagons and provisions to the incoming flood of homesteaders. Yet others are trying to stake out beautiful view lots that won’t be economically valuable but give a great view (and someday may therefore become valuable). And others are simply enjoying the run in the countryside, and are admiring their beautiful running form.
Many startups I see today are simply not venture investible. That doesn’t make them bad, just not good vehicles for VCs to invest in and get a return from. VCs have to return money to their investors. Hence they can only invest in a subset of the new ideas brewing out there, i.e. the ones that have the potential for a steep increase in economic value over a short period of time. And not likely to help the entrepreneur put food on the table.
But what happens if you can start a company with practically no money and no hassle pitching angels. My fear is that entrepreneurs will expend an enormous amount of effort launching a startup that can never become self sustaining. They have become enamored with their own idea and it’s novelty, and haven’t tested it outside of their narrow circle. And because they haven’t had to go out there and convince others that it’s a good idea --- and pitch the idea over and over again to investors --- adapt the idea to what seems to stick to the wall --- they will ultimately be wasting their time. It may be very worthwhile meaningful work, which makes a difference and draws huge traffic and changes the flow of homesteaders across the prairie, but doesn’t end up making the entrepreneur or their investors any return. In the end, it’s possible the entrepreneur will look back on these years as wasted --- benefiting others but not themselves.
What’s happening on the web is frequently cultural, and not necessarily economic. Great revolutionary businesses are being created, and great cultural changes are happening, but they don’t always overlap. And the test of a good idea is not that it is neat, or that it can be implemented simply and elegantly, or that it can draw many other’s curiosity and interest. The test of a good idea is the value others will place on it, and a good proxy for that value is the money they will pay for it. A good predictor of that value is whether others find it investible, be they angels or VCs.
So I think it is a good thing for entrepreneurs to have to pitch their ideas and convince others to put a value on it. I found in my own entrepreneurial career that my business models and even my technical ideas benefited from being pitched and explained to others. They became more focused and distinct. I recall A-HA moments that happened in front of prospective investors.
I worry about a world where doing things, making a big impact, affecting our culture in a big way, has such a very low cost of implementation. And even pitching some small investors isn’t necessary. I think it is bad even for the entrepreneurs who might seemingly benefit from it.
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.
Tuesday, October 2, 2007
How close is Too Close?
A common axiom is “Invest in what you know.” I want to amend it. “Invest in what you know enough about… but not too much about.”
I’m struck by something I see in my own investing behavior. In the market areas I have spent years getting to know intimately, I have a natural tendency to be pessimistic when presented with a new approach. It is only natural to think that if I didn’t see that idea when I was in the thick of it, why should it be so successful now. I’ve spent years understanding all the pitfalls around a market area --- to use medical devices as an example, I know all the regulatory and reimbursement and hospital politics reasons why a new device play could fail. I understand all those failure paths in gruesome detail. I’ve experienced them all.
You spend most of your operating years working through or around problems. The victories you zoom right through, like General Patton’s armies. You spend more time bogged down in the trenches than racing across the plains. So, what makes you grizzled --- “experienced” --- is the scars. You built that ego on the problems you have encountered and blown through. Your ego can now potentially blur your ability to see that the time is right for a major disruption in that market, or a revolutionary product approach.
In effect I’ve lived my life in the world of the past. But --- and it’s a big but, I haven’t lived in the future, yet. I’m still trying to get there. I truly don’t know the pitfalls of the future that well. Yes, I can extrapolate from past experience. But I want to suggest that VCs with extensive operating backgrounds may tend to be too pessimistic about new ventures that seek to enter their old stomping grounds. It’s only natural to remember the painful parts of the past. And you tend to take the things in your past that went well as just the planned outcome. It is harder to remember the successes of the future --- you can quote me on that one. But I think grizzled VCs can easily project their past travails onto the future.
So I think it’s possible to be TOO close to a market. You get comfortable that you understand the market with all its ins and outs, and then you miss the big hairy disruptive idea out of left field, or the new online way of getting to the patient.
The best VC positioning to evaluate a deal may be basically knowledgeable and able to ask penetrating questions, but also somewhat disengaged from that market and not too “invested” in the way it’s always been done. The best VCs are renaissance men, not domain specialists, in my humble opinion. You need to be able to peek over the horizon without being overly preoccupied about how you stumbled to get to this vantage point.
I’m struck by something I see in my own investing behavior. In the market areas I have spent years getting to know intimately, I have a natural tendency to be pessimistic when presented with a new approach. It is only natural to think that if I didn’t see that idea when I was in the thick of it, why should it be so successful now. I’ve spent years understanding all the pitfalls around a market area --- to use medical devices as an example, I know all the regulatory and reimbursement and hospital politics reasons why a new device play could fail. I understand all those failure paths in gruesome detail. I’ve experienced them all.
You spend most of your operating years working through or around problems. The victories you zoom right through, like General Patton’s armies. You spend more time bogged down in the trenches than racing across the plains. So, what makes you grizzled --- “experienced” --- is the scars. You built that ego on the problems you have encountered and blown through. Your ego can now potentially blur your ability to see that the time is right for a major disruption in that market, or a revolutionary product approach.
In effect I’ve lived my life in the world of the past. But --- and it’s a big but, I haven’t lived in the future, yet. I’m still trying to get there. I truly don’t know the pitfalls of the future that well. Yes, I can extrapolate from past experience. But I want to suggest that VCs with extensive operating backgrounds may tend to be too pessimistic about new ventures that seek to enter their old stomping grounds. It’s only natural to remember the painful parts of the past. And you tend to take the things in your past that went well as just the planned outcome. It is harder to remember the successes of the future --- you can quote me on that one. But I think grizzled VCs can easily project their past travails onto the future.
So I think it’s possible to be TOO close to a market. You get comfortable that you understand the market with all its ins and outs, and then you miss the big hairy disruptive idea out of left field, or the new online way of getting to the patient.
The best VC positioning to evaluate a deal may be basically knowledgeable and able to ask penetrating questions, but also somewhat disengaged from that market and not too “invested” in the way it’s always been done. The best VCs are renaissance men, not domain specialists, in my humble opinion. You need to be able to peek over the horizon without being overly preoccupied about how you stumbled to get to this vantage point.
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