by Krishna Mony
Throughout my career in Investment Banking for the past few years, and later in my careerist Private Equity / Venture Capital consulting avatar, I have often come across people seeking to explore our methods and processes. Here is a primer.
Our investment process is optimized to realize substantial returns from early-stage firms developing high valued-added core technology. Our process phases are:
1. Deal Flow
2. Evaluation
3. Selection
4. Decision
5. Value Creation
6. Liquidity Planning
These phases provide timely responses to entrepreneurs, ensure quality portfolio companies, and set the stage for our value-added model post-investment.
1. Deal Flow comes from our entrepreneur network, syndication partners, and later stage venture capital firms. These deal flow sources are attracted to us by our ability to perform due diligence and assist portfolio firms in achieving critical time-to-market milestones. Obtaining most of our deal flow from such qualified sources frees up more resources for building portfolio value.
2. Evaluation begins with the introduction of a business plan through one of the members of our network followed by a face-to-face meeting and subsequent investigation. We assesses the strength and completeness of the team, the company's technology, competitive advantage, target market, marketing plan, financial history and projections, and capital needs. The due diligence will include reference checks with customers, industry experts, and management references.
3. Selection is based on input from our Advisory Committee and analysis of team industry knowledge, technology development capabilities with a "deep science" orientation, portfolio fit, time-to-market focus, target market sizing and dynamics, competitive landscape and entry points, capitalization table, revenue projections and sales cycles, and recruiting capability.
4. Decision rests on discussions on perceived valuation, roles of both current and potential co-investors, and deal terms. A unanimous decision by the managing members is required to proceed with each investment.
5. Value Creation is achieved by assisting the portfolio company's management team in implementing and utilizing methodologies that manage and monitor time-to-market strategies using proven process models. Important ingredients in these models are a strong emphasis on early and frequent customer involvement in product development, concentration on differentiators, and recruitment of key contributors (advisors, executives, strategic partners).
6. Liquidity Planning is approached as a continuous process integral with value creation that provides multiple options. All management decisions are analyzed for strategic impact on liquidity paths with the intent of maximizing investor returns.
What do we do ?
1. These days, I head my consulting outfit Sequel Ventures based at Mumbai, India which hunts for the next wave of growth companies , where we syndicate investments in early stage technology firms from a network of Angels / VC partners. I specialize in finding and funding start-ups that aim at solving specific IT problems for big corporate users, drawing on our extensive network of business contacts, and my own corporate Investment Banking experience , to choose small companies that have the right mix of technology, strategy and leadership to thrive in the real world.
Among the investments that we have spearheaded for Sequel are stakes in a few incubatees in the Non-Conventional Energy Resource based projects, E-Commerce solutions, Commercial Avionics and a host of projects in BFSI verticals. We have also secured VC funding recently for an ITES project in the Telecom / Insurance vertical within a record 3 weeks.
The Challenge
Mastering the mix of business strategy and tech knowledge is the biggest challenge for both Angels and start-ups. That complexity, that diversity of skills and knowledge is what you need to be successful, and for your overall organization to be successful, at any level, according to us.
What are the primary factors that we look for in a company where we recommend a venture investment?
We look at investment opportunities that are oriented toward enabling growth at the companies that will buy the product, early-stage companies that are oriented toward reducing complexity and cutting costs, and companies concerned with reducing threats in the area of security—that kind of thing. It clearly has to be something that's solving a growing problem for potential customers. What we look for is a company that is producing a technology or an idea that can be sold directly to large corporations. Or it could be an enabling technology that gets sold to other technology companies that then produce it and sell it to the public or large technology companies.
Security continues to be a broadly defined growth area, in terms of both investment level and the size of the problem. It's pretty high on the IT budget. Another key area involves the switch-out at the data center from legacy technologies to newer technologies based on things like open-source, blade computing and storage-area networks. Another is a cost-effective management framework for a very different computing paradigm involving application servers and composite applications and Web services. Although certain costs in the new computing architecture have come way down, such as the cost of buying a server and buying a software license, other costs of managing that complexity and managing very high availability and responsiveness in this new architecture are still being worked on.
Do you do due diligence on Promoters / Projects before they are presented to Angels / VC partners ? What are your methods ?
Of course, we do. It makes the Angels / VC's in our network more comfortable since our methods complement theirs and are equally stringent in vetting a proposal. Hence we normally do not face any difficulties in securing funding for a project that we have cleared internally. We have a number of ways of analyzing the market. One is that we actively maintain relationships with IT buyers and senior executives to understand what's on their priority lists. We try to understand which areas are passé and already solved, and which they're really looking to their existing strategic suppliers to solve, versus the areas in which they feel their existing suppliers are unlikely to innovate.
Also, we would never recommend an investment without speaking to existing customers, prospective customers, and customers of competitors of the company, to understand how that market, that technology, that product and team were perceived. Now, having said that, if all you looked at were companies that were capitalizing on ideas and solving problems that were already defined and well known in the market, then you're not looking at things that are maybe five to ten years away.
We try to look at the great teams that are coming up with ideas that are a few generations out, that prospective customers maybe haven't thought about yet. That's risky. I mean, how many years have people been saying that this is the year of Web services, or of service-oriented architectures? And instead of it being a big wave, it's tending to be a very, very slow buildup. A lot of the momentum is going to depend on when the very big established suppliers, the Oracles, SAPs and IBMs, release their new products based on those architectures as much as when some new innovative start-up introduces something. Sometimes an entire market has to help make the move.
Some of the most important things you look for in a Project?
We mainly look for a great team. Brilliant minds, Independent thought leaders having a clear idea as regards their goals.
In investing in a tech start-up, the quality of the team, the quality of the people, is right up there in importance with the market opportunity and the product. So we might run into a market opportunity we think is excellent and a product we think is pretty darn good, but the team is not the right team for us to bet on. We don't think a company like that is going to win.
One of the primary reasons is that very young technology start-up companies rarely have the formula properly defined when they come and look for a first round of investment from VC's.
Any start-up is going to hit big forks in the road—more likely 90-degree turns, and not uncommonly U-turns. The ability of a team to be able to react to those major changes and make the right decisions and implement the right strategies to deal with huge mistakes and missed opportunities and poor analysis of the market is paramount for that company to ultimately succeed.
So the team is absolutely mandatory. And I'll tell you, it's a unique breed of people that will start as a group of three, four, five people and create a successful venture-funded, high-tech start-up. It's not just some good people. Ideally, they've been on a winning team as well as a losing team before, because you learn just as much from failure as from success. A lot of people say you learn more. And it requires just an unbelievable amount of energy and passion and enthusiasm and resilience, as well as business and technology acumen.
Getting the right mix, that magical team that comes together to make a start-up really successful, is not dissimilar to having an IT leadership team and a business leadership team at a much larger company—teams that come together with the right chemistry to result in the company being able to use IT for competitive advantage.
Remember this one thing. If you are not quite sure about your venture, chances are that the VC had already rejected it.
What else do Angels/VC's look for from the kind of companies you recommend funding - particularly on their business model when large corporations are projected as their customers ?
Well, I can tell you what is not on the list. And that is a traditional, high-risk, high-expense, low-rate-of-success implementations of complex application packages. The kind of company where all the money goes to the vendor upfront, and all the risk lies with the customer. A three-year implementation of a monolithic piece of software, with very complex integration, a big up-front license fee, and the risk being on the buyer rather than the seller, does not get a lot of traction. That era is over.
When corporations look at technology from small innovative start-ups, they expect a very different delivery model. They want business solutions to solve business problems, which fundamentally is application software delivered in some way, shape or form. They want it implemented quickly, and they want shared risk between the customer and the vendor, meaning that if the project doesn't succeed, the vendor doesn't still get to run all the way to the bank. They're looking for a more clear return on investment that is going to be easier to achieve without massive business process reengineering, which is high risk. And sometimes they're looking for flexibility—maybe the application being delivered as a managed service.
But are large companies willing to buy directly from these smaller start-up vendors?
I think many companies realize it is difficult for the very large technology suppliers to develop the most innovative solutions. And so companies need to push those large tech suppliers to continue to acquire companies for innovation purposes, as well as continuing to buy directly from smaller, innovative, venture-funded technology start-ups, to solve their most pressing tech problems.
When a small technology start-up goes to market in partnership with an existing supplier, that is often a big plus. It's not the only way to get success, but it's certainly one we like. It gets faster market traction and faster credibility. Customers like it, too. In fact, customers frequently drive it. It's one reason that acquisition activity by the big players is up significantly.
How fast can products actually go from the drawing board at a start-up to regular use at a large corporation?
In areas that are changing rapidly, like compliance issues related to Sarbanes-Oxley, things can happen very quickly. I've seen products in that area move to market within a couple of years. Storage continues to change very rapidly, and there are companies that just in the last three years have gone from idea or initial product to pretty good market traction.
The same is true of enabling technologies such as semiconductors and electronic design automation. Wireless is another great example. We've surveyed a number of companies that are selling wireless applications, and more companies are seeking easier access to critical information and applications through wireless and handheld platforms. So we have a whole host of areas where I would say there's been good business take-up, and some companies that we think are very promising that we've just recommended investing in maybe two, three, four years ago.
At the same time, the cycle from innovation to venture capital funding to corporate use is not even close to what it was the latter half of the 1990s, and I think it would be foolish to bet on that happening again any time soon. I think we're in more of a typical cycle now than in those years, and also more typical than maybe 2001 to 2003, which were very slow and difficult years. I'm not saying that happy days are here again. It's just that it's kind of back to the normal adoption cycles that we've seen over a long historical period of IT.
How can a Corporate Finance / Legal pro like you expect to keep up with all this technology change and still be an integral part of the business team, keeping up with strategy and even corporate politics?
Being a successful Investment Banker is a very complex and underappreciated job. It's a difficult job. You are not purely a technologist, but a Rain Maker; We all have seen during the earlier Tech Boom of the late 1990's that technology-driven CIOs can't achieve the necessary level of business partnership. You may still have to educate business management to look at IT as a key, strategic, enabling component of the successful business, even in this day and age. For that you have to learn it yourself quick. I've been a bit lucky because of my affinity to Math and Science during my School days.
But on top of all that, technology continues to change. Delivering the day-in, day-out performance that comes with the advance of technology, figuring out when to deploy new technologies, not being too bleeding-edge, but also not a laggard when technology can enable the business results you're looking for. There is a balance between being technology-driven and business-driven. It's critical to find that balance, but it is not easy, even today.
It must have been somewhat easier as a Management Executive, right? You didn't have to convince the boss that technology could be useful.
When I started at Coopers & Lybrand, there were not a lot of non-technology companies that were leaders in the use of technology. A non-technology company that was really enabling itself with technology was a new concept. Large technology companies took technology for granted, to be honest. It was often companies in other businesses, such as banking, with the ATM machine, or companies like FedEx, that were the big stories of competitive advantage in IT. They didn't come out of IT companies. They came out of consumer-products companies.
They came out of manufacturing companies, supply-chain companies. That culture had to be created within tech companies, including Coopers. I think that's part of what I was able to do there.
2009/05/14
A whole bunch of seed...
by Josh Kopelman,
I woke up this morning to some interesting news. Charles River Ventures is now investing at the seed-stage. This is a smart reaction on their part to several market trends:
The fact that it costs less to start a software/Internet business these days,
The fact that there are fewer large exits (both via IPO and M&A) taking place, and
The fact that, over the long-term (10+ years), seed-stage investing has had a higher return than any other stage of venture investing.
It also is a recognition of some of the challenges that larger venture funds face. Take a hypothetical traditional $400M VC firm. In order to achieve a 20% IRR, the fund must return 3x their initial capital over a 6 year term -- or $1.2B. Now say this hypothetical VC firm typically owns 20% of their portfolio companies at exit (an industry average). That means that at exit their portfolio needs to create $6 Billion dollars worth of market value (ie, $1.2B / 20%). Assuming that their average investment size is $20M, that means that they invest in 20 companies -- this assumes an average exit valuation of $300M PER COMPANY. Given the tight IPO Market and an average M&A exit value of less approximately $150M, this math creates some real challenges.
I've only interacted with Charles River a few times (we were co-investors in Odeo together) but think very highly of them. They have an enviable track record and a sterling reputation. I think they are one of a few pro-active venture firms who are proactively seeking new investment models (I've now heard of two other venture firms that are establishing seed-stage programs).
However, I've always thought that there were some inherent conflicts that arose when venture funds moved to the seed-stage. I'd be interested in hearing my readers thoughts on:
I've always believed that one of the key roles a seed-stage investor plays is to help their portfolio companies raise a Series A round. One of the reasons I don't like bridge loans, is that there is not alignment of interest between the lender and the entrepreneur. As a lender, I would convert into the price of the next round -- motivating me to keep the next round valuation low. As a shareholder, my motivation is aligned with the entrepreneur -- we both get rewarded by a higher second round valuation.
When an venture investor has an option (but not an obligation) to take a certain percentage of your next round, I've always thought it created the potential for some bad optics. If they exercise their option, and participate in the round, it could be a wonderful thing for the company. But if they choose not to exercise their option, what signal is it sending to other potential investors? As a small ($<50m) First Round Capital) to be a lead investor in subsequent rounds...But if a larger VC firm has the option anddoesn't use it -- does that cause other venture funds to wonder why?
Finally, as the First Round Capital website states, "we look to take an active role in most of the companies we invest in. We believe our insight and expertise are far more valuable than our capital -- and we look for entrepreneurs who feel the same." Our whole business model is to roll-up our sleeves and actively help the company develop it's strategy/partnerships/business model, etc. In fact, we tend to be far more active in the early-stages of a company than in the later stages. Given the size of larger VC funds, are their partners able to actively get involved in a seed-stage deal?
Thoughts?
UPDATE: Matt Marshall at VentureBeat has interesting insights here and Fred Wilson of Union Square shares his analysis here...
I woke up this morning to some interesting news. Charles River Ventures is now investing at the seed-stage. This is a smart reaction on their part to several market trends:
The fact that it costs less to start a software/Internet business these days,
The fact that there are fewer large exits (both via IPO and M&A) taking place, and
The fact that, over the long-term (10+ years), seed-stage investing has had a higher return than any other stage of venture investing.
It also is a recognition of some of the challenges that larger venture funds face. Take a hypothetical traditional $400M VC firm. In order to achieve a 20% IRR, the fund must return 3x their initial capital over a 6 year term -- or $1.2B. Now say this hypothetical VC firm typically owns 20% of their portfolio companies at exit (an industry average). That means that at exit their portfolio needs to create $6 Billion dollars worth of market value (ie, $1.2B / 20%). Assuming that their average investment size is $20M, that means that they invest in 20 companies -- this assumes an average exit valuation of $300M PER COMPANY. Given the tight IPO Market and an average M&A exit value of less approximately $150M, this math creates some real challenges.
I've only interacted with Charles River a few times (we were co-investors in Odeo together) but think very highly of them. They have an enviable track record and a sterling reputation. I think they are one of a few pro-active venture firms who are proactively seeking new investment models (I've now heard of two other venture firms that are establishing seed-stage programs).
However, I've always thought that there were some inherent conflicts that arose when venture funds moved to the seed-stage. I'd be interested in hearing my readers thoughts on:
I've always believed that one of the key roles a seed-stage investor plays is to help their portfolio companies raise a Series A round. One of the reasons I don't like bridge loans, is that there is not alignment of interest between the lender and the entrepreneur. As a lender, I would convert into the price of the next round -- motivating me to keep the next round valuation low. As a shareholder, my motivation is aligned with the entrepreneur -- we both get rewarded by a higher second round valuation.
When an venture investor has an option (but not an obligation) to take a certain percentage of your next round, I've always thought it created the potential for some bad optics. If they exercise their option, and participate in the round, it could be a wonderful thing for the company. But if they choose not to exercise their option, what signal is it sending to other potential investors? As a small ($<50m) First Round Capital) to be a lead investor in subsequent rounds...But if a larger VC firm has the option anddoesn't use it -- does that cause other venture funds to wonder why?
Finally, as the First Round Capital website states, "we look to take an active role in most of the companies we invest in. We believe our insight and expertise are far more valuable than our capital -- and we look for entrepreneurs who feel the same." Our whole business model is to roll-up our sleeves and actively help the company develop it's strategy/partnerships/business model, etc. In fact, we tend to be far more active in the early-stages of a company than in the later stages. Given the size of larger VC funds, are their partners able to actively get involved in a seed-stage deal?
Thoughts?
UPDATE: Matt Marshall at VentureBeat has interesting insights here and Fred Wilson of Union Square shares his analysis here...
Seven Lessons Learned for Startups
by David Beisel
"Input not consensus." – Scott K. While many have different views on management styles, I favor decision-making processes being inclusive to all parties who deserve to share their opinion, but having the ultimate decision made by a single person who is ultimately responsible for it. The problem with true consensus thinking isn't that good decisions don't come out of it, but rather that it's unclear when final decisions are made. Startup situations aren't the right place for muddled thinking or unclear directives. Once a decision has been made, owners of responsibility must immediately run off and execute. Although many extremely successful organizations were built on consensus-driven cultures, my opinion is that there isn't time for it in a startup - but there is absolutely time for everyone's input.
"Be authentic." – Mark L. I believe most successful entrepreneurial endeavors are sprung from a genuine idea born from true experience or direct & tangible observation. Companies that emerge out of a team with heritage in a particular market and technology have direct understanding of that realm. Furthermore, when employees act in an open and authentic manner with each other, it helps foster a team environment which is productive for everyone. It is with this authentic foundation that great companies are built.
"Dead cats don’t bounce." – Joe G. Unfortunately, many many startups do not succeed. It takes a strong entrepreneur to admit when a particular project, product, or company isn't destined for success. (Often those failures lead to learning experiences from which new successes are born.) But if something isn't going to take on life, startups must realize when that's the case and move beyond the fleeting hope for it to take off.
"Solid-gold relationships." – Bill A. The most important relationship that any company has is with its customers. And the most important of those are the key large or influential customers. It is with those special constituents - whether they are consumers, SMBs, or enterprises – that should be nurtured and cared for. Not only do they provide the (first) notable revenue, but also necessary market feedback for further refining the product offering. With all of the distractions that arise in a startup setting, it's extremely important to keep focused on cultivating these special relationships.
"Get involved." – John C. I used to have this quote from a former boss hanging above my desk. A daily reminder that when deciding whether to take action, experiment, or try something new, it is usually better to take this route than to not.
"Take time to think." – Kelley M. While action is always a priority, deciding the correct action often requires reflection. Dedicating time during a critical juncture in a project or undertaking to leave time for unstructured individual contemplation of the larger current work situation provides an opportunity for everyone to obtain a richer perspective. It's an underutilized tool to require that people occasionally briefly pause from the task-oriented workday (not just to provide brief respite from the pile of to-do's, but) to contemplate what efforts truly will have the most impact on the company.
"Reward those who deserve it." – Kevin M. Credit should go where credit is due, with the right people rewarded for their efforts. And that doesn't just mean appropriately compensating people financially. Particularly in a startup where there is less cash to share, recognition and acknowledgement of accomplishment goes a long way. A long way.
(The above mantras are obviously not the only, nor are they necessarily the best, words of wisdom which I've ever received. However, they are the ones that have sunk in internally for me the most. While this is a professional post, it is also a personal one as well, as I am extremely appreciative of those listed above who have made a direct impact on my own thinking and direction over the years and will continue to do so.)
"Input not consensus." – Scott K. While many have different views on management styles, I favor decision-making processes being inclusive to all parties who deserve to share their opinion, but having the ultimate decision made by a single person who is ultimately responsible for it. The problem with true consensus thinking isn't that good decisions don't come out of it, but rather that it's unclear when final decisions are made. Startup situations aren't the right place for muddled thinking or unclear directives. Once a decision has been made, owners of responsibility must immediately run off and execute. Although many extremely successful organizations were built on consensus-driven cultures, my opinion is that there isn't time for it in a startup - but there is absolutely time for everyone's input.
"Be authentic." – Mark L. I believe most successful entrepreneurial endeavors are sprung from a genuine idea born from true experience or direct & tangible observation. Companies that emerge out of a team with heritage in a particular market and technology have direct understanding of that realm. Furthermore, when employees act in an open and authentic manner with each other, it helps foster a team environment which is productive for everyone. It is with this authentic foundation that great companies are built.
"Dead cats don’t bounce." – Joe G. Unfortunately, many many startups do not succeed. It takes a strong entrepreneur to admit when a particular project, product, or company isn't destined for success. (Often those failures lead to learning experiences from which new successes are born.) But if something isn't going to take on life, startups must realize when that's the case and move beyond the fleeting hope for it to take off.
"Solid-gold relationships." – Bill A. The most important relationship that any company has is with its customers. And the most important of those are the key large or influential customers. It is with those special constituents - whether they are consumers, SMBs, or enterprises – that should be nurtured and cared for. Not only do they provide the (first) notable revenue, but also necessary market feedback for further refining the product offering. With all of the distractions that arise in a startup setting, it's extremely important to keep focused on cultivating these special relationships.
"Get involved." – John C. I used to have this quote from a former boss hanging above my desk. A daily reminder that when deciding whether to take action, experiment, or try something new, it is usually better to take this route than to not.
"Take time to think." – Kelley M. While action is always a priority, deciding the correct action often requires reflection. Dedicating time during a critical juncture in a project or undertaking to leave time for unstructured individual contemplation of the larger current work situation provides an opportunity for everyone to obtain a richer perspective. It's an underutilized tool to require that people occasionally briefly pause from the task-oriented workday (not just to provide brief respite from the pile of to-do's, but) to contemplate what efforts truly will have the most impact on the company.
"Reward those who deserve it." – Kevin M. Credit should go where credit is due, with the right people rewarded for their efforts. And that doesn't just mean appropriately compensating people financially. Particularly in a startup where there is less cash to share, recognition and acknowledgement of accomplishment goes a long way. A long way.
(The above mantras are obviously not the only, nor are they necessarily the best, words of wisdom which I've ever received. However, they are the ones that have sunk in internally for me the most. While this is a professional post, it is also a personal one as well, as I am extremely appreciative of those listed above who have made a direct impact on my own thinking and direction over the years and will continue to do so.)
The Art of Selling Your Firm
by Matt McCall
Despite the markets' gyrations, 2008 was the best year for liquidity in our firm's history. In fact, our largest exit (Lefthand Networks) closed in November in the heart of the downdraft. In looking across these exits, the strong exits all had several common elements:
1) Self-sufficiency: the old saying in venture is that companies are bought and not sold. If the acquiror knows that time is it's friend, they will slow roll the process, driving harder terms with each passing month. Don't go into the process without a long runway (or a strong forcing mechanism). Your gut will tell you how much of the process is your pushing versus their pulling. Don't push.
2) Mortal Enemies: the surest way to have a healthy process is to get two bidders that viciously compete with each other. During one process, we tried to leverage a weaker competitor to motivate our lead buyer. They laughed and encouraged us to sell to them. We subsequently engaged their fierce competitor. The result: LOI in weeks, closed in 6 weeks.
3) Existing Relationship: people do deals with people they know. You can either try to convey your value during an impersonal pitch or let them experience the specific facets/nuances of your firm or technology through interacting with you over time. Most firms know who are the likely buyers. During this downdraft, it is a good time to build these relationships. You can get their attention if you can deliver revenue to them or reduce concrete costs. Don't ever taint this process by pushing or even hinting at selling the firm as it will set you back.
4) Few Alternatives: scarcity is at the heart of a good sale. Few or inferior alternatives swings the balance in your direction. If there are an array of available solutions, you will lose your leverage in the process. A superior/strong product can sell itself. If you have strong synergies with competitors,you can carefully & selectively consolidate or rationalize your sector. Now is the time to distance yourself from the pack, outlive competition and consolidate so you are the logical acquisition.
5) Visible Scalable: you invest in companies if they demonstrate a scaling revenue model which has visibility on the growth drivers going forward. Acquirors will do the same. Have you proven out your revenue model and can you show how it will ramp significantly if owned by them. Show it becomes more profitable with them.
6) Strategically Central: if your product or service is a central component to the acquiror's future, you will get attention. If not, you may likely get lost in the noise. This can be the product that is missing but is a key growth driver in their industry or can protect/enhance core existing products.
So, while exits are harder today, now is a key time to position for exits when the conditions improve in coming years. Build relationships now that will be essential later.
Despite the markets' gyrations, 2008 was the best year for liquidity in our firm's history. In fact, our largest exit (Lefthand Networks) closed in November in the heart of the downdraft. In looking across these exits, the strong exits all had several common elements:
1) Self-sufficiency: the old saying in venture is that companies are bought and not sold. If the acquiror knows that time is it's friend, they will slow roll the process, driving harder terms with each passing month. Don't go into the process without a long runway (or a strong forcing mechanism). Your gut will tell you how much of the process is your pushing versus their pulling. Don't push.
2) Mortal Enemies: the surest way to have a healthy process is to get two bidders that viciously compete with each other. During one process, we tried to leverage a weaker competitor to motivate our lead buyer. They laughed and encouraged us to sell to them. We subsequently engaged their fierce competitor. The result: LOI in weeks, closed in 6 weeks.
3) Existing Relationship: people do deals with people they know. You can either try to convey your value during an impersonal pitch or let them experience the specific facets/nuances of your firm or technology through interacting with you over time. Most firms know who are the likely buyers. During this downdraft, it is a good time to build these relationships. You can get their attention if you can deliver revenue to them or reduce concrete costs. Don't ever taint this process by pushing or even hinting at selling the firm as it will set you back.
4) Few Alternatives: scarcity is at the heart of a good sale. Few or inferior alternatives swings the balance in your direction. If there are an array of available solutions, you will lose your leverage in the process. A superior/strong product can sell itself. If you have strong synergies with competitors,you can carefully & selectively consolidate or rationalize your sector. Now is the time to distance yourself from the pack, outlive competition and consolidate so you are the logical acquisition.
5) Visible Scalable: you invest in companies if they demonstrate a scaling revenue model which has visibility on the growth drivers going forward. Acquirors will do the same. Have you proven out your revenue model and can you show how it will ramp significantly if owned by them. Show it becomes more profitable with them.
6) Strategically Central: if your product or service is a central component to the acquiror's future, you will get attention. If not, you may likely get lost in the noise. This can be the product that is missing but is a key growth driver in their industry or can protect/enhance core existing products.
So, while exits are harder today, now is a key time to position for exits when the conditions improve in coming years. Build relationships now that will be essential later.
Multiples vs IRR
by Matt McCall
I was at a business school today helping judge several business plans. As group after group presented, I saw each make the same mistake as the previous. When they tried to justify the investment from the perspective of the VC, they kept telling us that this was a 40% IRR deal or a 25% IRR as if we had magical IRR thresholds.
The reality is that the venture world is all about multiples and the IRR's are the results. I don't know what the original legacy behind this was, but from a practical perspective, it is driven mostly by the fact that we live in a boolean world. Some is also based upon the high net worth legacy of our business. Originally, because pension law did not permit the large institutional investors in, our business was funded by family offices, endowments and foundations. Multi-generational families, while they want high IRR's, are really looking to double or triple their invested capital.
From a portfolio perspective, if we invest in 10 deals, 4 are tube shots, 2 we fight to get our money back on, 2-3 we get 2-5x on and the 10th deal drives the return (hopefully north of 10x). If we doubled our money in 1 year (100% IRR) but lost all our money on the next deal over 6 years, we aren't happy (net gain is $0). We don't care that we made 2x in 1 versus 3 years or lost all of our money over 6 years versus 4 years (this impacts IRR), because we earned 1x on the capital.
We often see complex financial models with discounted cash flows, hurdle rates and such. These are useless. I have never seen a set of financials in an early stage company that ever reflect what Darwin will allow to happen in reality. So, you start your modeling with unreliable numbers.
Secondly, what is the beta for an early stage biotech deal, a semi-conductor start-up, etc? Can you assess the risk associated with a given management team? How about a new market space?
Perhaps we are too lazy to try and figure this out, but after decades of effort, the only method that seems to work in the venture world is to target 10x on each early stage deal (3-5x on later stage plays). They all look like the next Microsoft, but eventually, the portfolio of these settles down to the profile above. In the early stage world, if you target, say a 40% IRR, through assuming a number of 5x wins in a compressed period of time, you will likely be out of the business. Your 5x wins, while possibly generating high IRR's, don't return enough multiple to pay for the 4 tube shots and 2 break-even deals. Your winners need to deliver 10x.
So, next time you are trying to convince a VC about the merits of your firm, show them how they can make 10x capital on a realistic exit scenario (not how to get a 40% IRR).
I was at a business school today helping judge several business plans. As group after group presented, I saw each make the same mistake as the previous. When they tried to justify the investment from the perspective of the VC, they kept telling us that this was a 40% IRR deal or a 25% IRR as if we had magical IRR thresholds.
The reality is that the venture world is all about multiples and the IRR's are the results. I don't know what the original legacy behind this was, but from a practical perspective, it is driven mostly by the fact that we live in a boolean world. Some is also based upon the high net worth legacy of our business. Originally, because pension law did not permit the large institutional investors in, our business was funded by family offices, endowments and foundations. Multi-generational families, while they want high IRR's, are really looking to double or triple their invested capital.
From a portfolio perspective, if we invest in 10 deals, 4 are tube shots, 2 we fight to get our money back on, 2-3 we get 2-5x on and the 10th deal drives the return (hopefully north of 10x). If we doubled our money in 1 year (100% IRR) but lost all our money on the next deal over 6 years, we aren't happy (net gain is $0). We don't care that we made 2x in 1 versus 3 years or lost all of our money over 6 years versus 4 years (this impacts IRR), because we earned 1x on the capital.
We often see complex financial models with discounted cash flows, hurdle rates and such. These are useless. I have never seen a set of financials in an early stage company that ever reflect what Darwin will allow to happen in reality. So, you start your modeling with unreliable numbers.
Secondly, what is the beta for an early stage biotech deal, a semi-conductor start-up, etc? Can you assess the risk associated with a given management team? How about a new market space?
Perhaps we are too lazy to try and figure this out, but after decades of effort, the only method that seems to work in the venture world is to target 10x on each early stage deal (3-5x on later stage plays). They all look like the next Microsoft, but eventually, the portfolio of these settles down to the profile above. In the early stage world, if you target, say a 40% IRR, through assuming a number of 5x wins in a compressed period of time, you will likely be out of the business. Your 5x wins, while possibly generating high IRR's, don't return enough multiple to pay for the 4 tube shots and 2 break-even deals. Your winners need to deliver 10x.
So, next time you are trying to convince a VC about the merits of your firm, show them how they can make 10x capital on a realistic exit scenario (not how to get a 40% IRR).
Venture Capital in China
By David Hornik on January 5, 2008 1:17 AM Permalink
For the last several years there has been a lot of talk on Sand Hill Road about investing in China. To a certain degree there has been a lot of talk about all the BRIC countries -- Brazil, Russia, India and China. But the most excitement is clearly around China. (Interestingly, while India is a relatively close second, I have yet to hear of a single Bay Area VC exploring investment in either Brazil or Russia). Drawn by huge markets and a rapidly expanding economy, American VC's are heading to China to stake their claims. Go East young VC's. Go East.
Venture Capital investment in China has not, however, been a headlong dive. Bay Area VC's seem to be sending over exploratory parties. By way of example, David Chao from Doll Capital has been in and out of China for some time. Now a number of his partners are getting in on the act as well. Paul Koontz from Foundation Capital spent a year in China exploring the market. And perhaps the best indicator that the Chinese market is hot is Dick Kramlich's pilgrimage to China this year. Kramlich is one of the founding fathers of Sand Hill Road -- a 25 year veteran of the venture capital business. Not one to miss out on a big opportunity, Kramlich has headed over to China for 2008 to catch the wave of entrepreneurship and, perhaps, some of the Beijing olympics. Chow, Koontz and Kramlich are not the only US VC's headed to China by any stretch of the imagination. But these high profile forays into the Chinese market are excellent indicators of the level of interest in the market.
It is hard not to be intrigued by the Chinese market. With 1.3 Billion people, you don't need a huge amount of penetration to hit big numbers. One percent of the Chinese market is 13 million people. As they say, if you are "one in a million" in China, there are thirteen-hundred people just like you. What's more, the Chinese government anticipates that approximately 300 Million people will move from the countryside to urban centers in the next decade -- that's the same number as the entire population of the United States. The combination of massive aggregate numbers, rapid urban migration (and the commensurate increase in wages) and relatively low concentrations of modernized business processes, suggest a market ripe for investment. And that is precisely the conclusion many of my brethren on Sand Hill Road have drawn.
Given all that, I was anxious to check out China for myself. And right before the new year, I had the good fortune to do just that -- I accompanied a group of Stanford Business School students on a ten day study trip to China. We met with senior executives from companies like China Telecom, Alibaba, GM China and Bao Steel, as well as senior government officials and party leaders (yes, it is still a Communist country). But the most interesting discussions, to my mind, were with the leading private investors in China. (Because my meetings with these private investors took place as part of a study trip, there was no expectation that I would blog about the content of our conversations -- thus, I have decided to exclude the names of the specific investors so as not to violate any confidences they may have reasonable expected.) These investors gave a surprisingly candid view of venture capital throughout the country -- the good, the bad and the ugly.
To the mind of the Chinese investing community, the market dynamics described above well outweigh the risks of investing in the current environment. Huge markets with lots of business white space provides for numerous opportunities for economic gain. While American investors are busy debating the degree to which the US startup market is saturated, Chinese investors are having trouble keeping up with the inflow of opportunities. The opportunities in China seem unbounded, making foreign investors starry-eyed. But despite the glories of the Chinese market -- and there is no denying that the demographic trends in China are glorious -- I heard more than enough from Chinese investors to scare me away from the market.
As an initial matter, the biggest challenge that investors find in building Chinese startups is identifying great entrepreneurs. Because there has been all but no startup culture prior to a handful of years ago, there are essentially no seasoned entrepreneurs. A few native Chinese business expats are returning from abroad to take advantage of China's increasingly open economy. But those numbers are de minimis and do nothing to staff the rest of the enterprise. Meanwhile, Chinese executives have been trained to function in a business culture of bureaucracy and Party connections -- not the fast-paced, fluid environment of the startup world. The investors with whom I met lamented the lack of qualified executives and warned about the significant challenges of doing diligence on Chinese entrepreneurs.
The second challenge with entrepreneurship in China is grounded in the laws of China. The legal structures needed to support a vibrant startup economy are, at best, embryonic. Neither entrepreneurs nor investors are particularly well protected by the Chinese legal system. One investor with who I met on my trip described a recent situation in which he funded an entrepreneur, only to have that entrepreneur turn around and leave for business school months later. The entrepreneur assured the investor that he would be better situated to make the business a success after the two years of school. The investor had no recourse as his money left the country with the entrepreneur. In another instance, an investor backed an entrepreneur in a business that thereafter appeared to be failing. However, a couple years later when the same company started thriving, the entrepreneur informed the investor that it was not the company he had backed. The investor was incredulous. He told the entrepreneur that it was the very same company with the same team and even the same name. The entrepreneur assured the investor that it was, in fact, a different company and that he had not invested in this successful company, his investment was in the previous failed venture. Despite the obvious deception, the investor told me that he again had no legal recourse.
In many ways, venture capital in China is like the wild west. There are big opportunities, but they are not well defined and capturing their full value may well require manipulating the law to your own devices. One investor with whom I met described entrepreneurship in the United States like a zoo and entrepreneurship in China like a jungle. In the United States, he said, while there is always a lion next to you with sharp claws, driven by self-interest, there is a cage between you and the lion to keep you safe. You can count on the cage to protect you from unreasonable or illegal behavior. In China, on the other hand, there is no cage between you and the Lion -- if you don't take great pains to protect yourself from the self-interested behavior of the lion, you are going to get bitten. Case in point, one Chinese executive with whom I met on my trip described how he was able to leverage his dominant market position to force his competitors to sell at a discount. What's more, the entrepreneur described with pride that once he had bought up all of his competition, he was able to raise his prices three-fold.
Yet another significant challenge for United States VC's seeking to invest in China is the government itself. While China appears to be making huge market-driven strides in its economy, there remains a significant wild-card in all business transactions -- the Communist government. On my trip it was repeatedly pointed out to us that government officials don't make laws, Party leaders do. The government officials are tasked with managing the bureaucracies of their localities, but the party leaders are tasked with making the decisions. The Communist Party single-handedly makes all of the rules in China. For example, by mandate of the Party, no Chinese financial institution may be majority-owned by foreign investors. Thus, the fasted growing segment of the Chinese market is off-limits to foreign investment. What is to stop the Chinese government from making similar mandates in other market segments? This lack of predictability of the fundament legal underpinnings of business in China is sufficient in and of itself to make me take pause.
I thoroughly enjoyed my visit to China. The shear scale of Beijing and Shanghai was absolutely stunning, as was the velocity of the growth in both cities. And the extraordinarily candid conversations we had with Chinese business leaders and Party officials was both surprising and invaluable. But rather than leaving China emboldened to invest in their great economy, I returned to the United States surprised that my fellow VC's could accept the risks inherent in investing in China. I could not. And I don't anticipate that changing any time soon.
some Comments
------------------------
Don Dodge said:
David, Thanks for the thoughtful review of the VC investment situation in China. I know several VCs who are excited about the opportunities in China and who have sent lots of money and people there, but I am with you, I think the risks are too high.
I spent 5 weeks in China on 4 separate trips back in 1997 / 1998. I haven't been back since. I was hoping the situation had improved since then. Sounds like it hasn't.
The prevailing attitude then was that "profit" was evil. Essentially "profit" by a foriegn company was considered stealing money from the Chinese people. Even if you could structure some kind of deal that resulted in a profit...good luck trying to take that profit back to the USA. Money made in China stayed in China. There was no reasonable way to "repatriate" profits back to the USA. Has that changed?
Back then most business deals were structured as partnerships with China based "companies". I use the term company loosely because they were all ultimately owned by a China government agency. Sometimes the company names would make you believe they were a real for profit company, but if you dug deeper you would find out they were really owned by some government agency.
The "partnerships" always boiled down to the same theme...the USA company provides the dollars and technology, while China provides the cheap labor, land, and facilities. Any resulting profit stayed in China.
Selling software in China was difficult then. There were no intellectual property laws, no copyrights, no trademarks. And even if such laws did exist...they were never enforced. Just take a look at any store in China loaded with "Gucci" watches, "Nike" shoes, or "Microsoft" software. It was all cheap knock-offs where the brand, logo, and intellectual property was stolen. Has that changed in 10 years?
It is hard enough to launch a successful startup in the USA with all the laws and protections we have here. Imagine trying to start a company in China with all the additional risks you have mentioned. It is enormously difficult and risky. And if you are extremely lucky and succeed...will you be able to keep your profits and convert them to US dollars?
I hope a lot has changed since I tried to do business in China 10 years ago. Based on your observations it sunds like they still have a long way to go.
--------------------
David,
Having both started and invested in a number of businesses myself, I am not surprised by the anecdotes you heard and can see why you were turned off by them. You certainly went one step beyond the simple fascination with China of "fly-in" Western investors.
On the other hand, the "Wild Wests" and jungles (I would say the defining characteristic of this jungle is not the lack of cages but rather than the lack of rules, compared to the zoo) is where money has been and will be made. In the U.S., many industries emerged out of chaos characterized by the same excess and sometimes fraud, and the same lack of rules and clarity. The Internet bubble of the late 1990s is one of them.
No doubt many investors will lose their shirts in China. Many mistakes have been made due to inexperience (mainly on the part of the local investors) and lack of local knowledge and networks (the foreign investors), or both (a surprising large number).
The lack of good entrepreneurs and managers is a real challenge. It is however relative: the investee's competitor has the same issue. A personal network for recruiting and vetting is important in China, as it is in the U.S. Due to a number of reasons, inexperienced entrepreneurs among them, my view is that in China the good VCs can add far more value than they can in the U.S. Unfortunately very few VCs in China have the experience and inclination to add value, particularly when the prevailing wind is "get rich quick".
The real challenge for me is finding entrepreneurs whom I can trust and who is scalable (can be trusted by his/her employees, among other things), but who can be "flexible" when dealing with the external environment. It invariably involves some compromise.
From the perspective of Western VC firms, success will come from the quality of the local China investing team and whether the local team is empowered. Fortunately it is much easier to empower the local team via the VC partnership structure than, say, via subsidiary structures of publicly listed NASDAQ companies, whose performance in China has been abysmal indeed.
Bo Shao
For the last several years there has been a lot of talk on Sand Hill Road about investing in China. To a certain degree there has been a lot of talk about all the BRIC countries -- Brazil, Russia, India and China. But the most excitement is clearly around China. (Interestingly, while India is a relatively close second, I have yet to hear of a single Bay Area VC exploring investment in either Brazil or Russia). Drawn by huge markets and a rapidly expanding economy, American VC's are heading to China to stake their claims. Go East young VC's. Go East.
Venture Capital investment in China has not, however, been a headlong dive. Bay Area VC's seem to be sending over exploratory parties. By way of example, David Chao from Doll Capital has been in and out of China for some time. Now a number of his partners are getting in on the act as well. Paul Koontz from Foundation Capital spent a year in China exploring the market. And perhaps the best indicator that the Chinese market is hot is Dick Kramlich's pilgrimage to China this year. Kramlich is one of the founding fathers of Sand Hill Road -- a 25 year veteran of the venture capital business. Not one to miss out on a big opportunity, Kramlich has headed over to China for 2008 to catch the wave of entrepreneurship and, perhaps, some of the Beijing olympics. Chow, Koontz and Kramlich are not the only US VC's headed to China by any stretch of the imagination. But these high profile forays into the Chinese market are excellent indicators of the level of interest in the market.
It is hard not to be intrigued by the Chinese market. With 1.3 Billion people, you don't need a huge amount of penetration to hit big numbers. One percent of the Chinese market is 13 million people. As they say, if you are "one in a million" in China, there are thirteen-hundred people just like you. What's more, the Chinese government anticipates that approximately 300 Million people will move from the countryside to urban centers in the next decade -- that's the same number as the entire population of the United States. The combination of massive aggregate numbers, rapid urban migration (and the commensurate increase in wages) and relatively low concentrations of modernized business processes, suggest a market ripe for investment. And that is precisely the conclusion many of my brethren on Sand Hill Road have drawn.
Given all that, I was anxious to check out China for myself. And right before the new year, I had the good fortune to do just that -- I accompanied a group of Stanford Business School students on a ten day study trip to China. We met with senior executives from companies like China Telecom, Alibaba, GM China and Bao Steel, as well as senior government officials and party leaders (yes, it is still a Communist country). But the most interesting discussions, to my mind, were with the leading private investors in China. (Because my meetings with these private investors took place as part of a study trip, there was no expectation that I would blog about the content of our conversations -- thus, I have decided to exclude the names of the specific investors so as not to violate any confidences they may have reasonable expected.) These investors gave a surprisingly candid view of venture capital throughout the country -- the good, the bad and the ugly.
To the mind of the Chinese investing community, the market dynamics described above well outweigh the risks of investing in the current environment. Huge markets with lots of business white space provides for numerous opportunities for economic gain. While American investors are busy debating the degree to which the US startup market is saturated, Chinese investors are having trouble keeping up with the inflow of opportunities. The opportunities in China seem unbounded, making foreign investors starry-eyed. But despite the glories of the Chinese market -- and there is no denying that the demographic trends in China are glorious -- I heard more than enough from Chinese investors to scare me away from the market.
As an initial matter, the biggest challenge that investors find in building Chinese startups is identifying great entrepreneurs. Because there has been all but no startup culture prior to a handful of years ago, there are essentially no seasoned entrepreneurs. A few native Chinese business expats are returning from abroad to take advantage of China's increasingly open economy. But those numbers are de minimis and do nothing to staff the rest of the enterprise. Meanwhile, Chinese executives have been trained to function in a business culture of bureaucracy and Party connections -- not the fast-paced, fluid environment of the startup world. The investors with whom I met lamented the lack of qualified executives and warned about the significant challenges of doing diligence on Chinese entrepreneurs.
The second challenge with entrepreneurship in China is grounded in the laws of China. The legal structures needed to support a vibrant startup economy are, at best, embryonic. Neither entrepreneurs nor investors are particularly well protected by the Chinese legal system. One investor with who I met on my trip described a recent situation in which he funded an entrepreneur, only to have that entrepreneur turn around and leave for business school months later. The entrepreneur assured the investor that he would be better situated to make the business a success after the two years of school. The investor had no recourse as his money left the country with the entrepreneur. In another instance, an investor backed an entrepreneur in a business that thereafter appeared to be failing. However, a couple years later when the same company started thriving, the entrepreneur informed the investor that it was not the company he had backed. The investor was incredulous. He told the entrepreneur that it was the very same company with the same team and even the same name. The entrepreneur assured the investor that it was, in fact, a different company and that he had not invested in this successful company, his investment was in the previous failed venture. Despite the obvious deception, the investor told me that he again had no legal recourse.
In many ways, venture capital in China is like the wild west. There are big opportunities, but they are not well defined and capturing their full value may well require manipulating the law to your own devices. One investor with whom I met described entrepreneurship in the United States like a zoo and entrepreneurship in China like a jungle. In the United States, he said, while there is always a lion next to you with sharp claws, driven by self-interest, there is a cage between you and the lion to keep you safe. You can count on the cage to protect you from unreasonable or illegal behavior. In China, on the other hand, there is no cage between you and the Lion -- if you don't take great pains to protect yourself from the self-interested behavior of the lion, you are going to get bitten. Case in point, one Chinese executive with whom I met on my trip described how he was able to leverage his dominant market position to force his competitors to sell at a discount. What's more, the entrepreneur described with pride that once he had bought up all of his competition, he was able to raise his prices three-fold.
Yet another significant challenge for United States VC's seeking to invest in China is the government itself. While China appears to be making huge market-driven strides in its economy, there remains a significant wild-card in all business transactions -- the Communist government. On my trip it was repeatedly pointed out to us that government officials don't make laws, Party leaders do. The government officials are tasked with managing the bureaucracies of their localities, but the party leaders are tasked with making the decisions. The Communist Party single-handedly makes all of the rules in China. For example, by mandate of the Party, no Chinese financial institution may be majority-owned by foreign investors. Thus, the fasted growing segment of the Chinese market is off-limits to foreign investment. What is to stop the Chinese government from making similar mandates in other market segments? This lack of predictability of the fundament legal underpinnings of business in China is sufficient in and of itself to make me take pause.
I thoroughly enjoyed my visit to China. The shear scale of Beijing and Shanghai was absolutely stunning, as was the velocity of the growth in both cities. And the extraordinarily candid conversations we had with Chinese business leaders and Party officials was both surprising and invaluable. But rather than leaving China emboldened to invest in their great economy, I returned to the United States surprised that my fellow VC's could accept the risks inherent in investing in China. I could not. And I don't anticipate that changing any time soon.
some Comments
------------------------
Don Dodge said:
David, Thanks for the thoughtful review of the VC investment situation in China. I know several VCs who are excited about the opportunities in China and who have sent lots of money and people there, but I am with you, I think the risks are too high.
I spent 5 weeks in China on 4 separate trips back in 1997 / 1998. I haven't been back since. I was hoping the situation had improved since then. Sounds like it hasn't.
The prevailing attitude then was that "profit" was evil. Essentially "profit" by a foriegn company was considered stealing money from the Chinese people. Even if you could structure some kind of deal that resulted in a profit...good luck trying to take that profit back to the USA. Money made in China stayed in China. There was no reasonable way to "repatriate" profits back to the USA. Has that changed?
Back then most business deals were structured as partnerships with China based "companies". I use the term company loosely because they were all ultimately owned by a China government agency. Sometimes the company names would make you believe they were a real for profit company, but if you dug deeper you would find out they were really owned by some government agency.
The "partnerships" always boiled down to the same theme...the USA company provides the dollars and technology, while China provides the cheap labor, land, and facilities. Any resulting profit stayed in China.
Selling software in China was difficult then. There were no intellectual property laws, no copyrights, no trademarks. And even if such laws did exist...they were never enforced. Just take a look at any store in China loaded with "Gucci" watches, "Nike" shoes, or "Microsoft" software. It was all cheap knock-offs where the brand, logo, and intellectual property was stolen. Has that changed in 10 years?
It is hard enough to launch a successful startup in the USA with all the laws and protections we have here. Imagine trying to start a company in China with all the additional risks you have mentioned. It is enormously difficult and risky. And if you are extremely lucky and succeed...will you be able to keep your profits and convert them to US dollars?
I hope a lot has changed since I tried to do business in China 10 years ago. Based on your observations it sunds like they still have a long way to go.
--------------------
David,
Having both started and invested in a number of businesses myself, I am not surprised by the anecdotes you heard and can see why you were turned off by them. You certainly went one step beyond the simple fascination with China of "fly-in" Western investors.
On the other hand, the "Wild Wests" and jungles (I would say the defining characteristic of this jungle is not the lack of cages but rather than the lack of rules, compared to the zoo) is where money has been and will be made. In the U.S., many industries emerged out of chaos characterized by the same excess and sometimes fraud, and the same lack of rules and clarity. The Internet bubble of the late 1990s is one of them.
No doubt many investors will lose their shirts in China. Many mistakes have been made due to inexperience (mainly on the part of the local investors) and lack of local knowledge and networks (the foreign investors), or both (a surprising large number).
The lack of good entrepreneurs and managers is a real challenge. It is however relative: the investee's competitor has the same issue. A personal network for recruiting and vetting is important in China, as it is in the U.S. Due to a number of reasons, inexperienced entrepreneurs among them, my view is that in China the good VCs can add far more value than they can in the U.S. Unfortunately very few VCs in China have the experience and inclination to add value, particularly when the prevailing wind is "get rich quick".
The real challenge for me is finding entrepreneurs whom I can trust and who is scalable (can be trusted by his/her employees, among other things), but who can be "flexible" when dealing with the external environment. It invariably involves some compromise.
From the perspective of Western VC firms, success will come from the quality of the local China investing team and whether the local team is empowered. Fortunately it is much easier to empower the local team via the VC partnership structure than, say, via subsidiary structures of publicly listed NASDAQ companies, whose performance in China has been abysmal indeed.
Bo Shao
Startup Valuation - The VC Method
by Ryan Junee
Anyone from the valley will agree there is a certain buzz in the air right now - a buzz very reminiscent of the late 90s. Not only does it remind us of the good times, but also of the dangers of getting ‘caught up in the hype’. It seems everyone is all too aware of this becoming another ‘bubble’ - and everyone, including myself, seems to be cautious about valuing new startups using ‘bubble era’ metrics.
So how should one value a startup? It’s obviously a difficult question because the company typically has no revenues, few assets (apart from people and some IP), and cannot be traded in a market with enough participants (and enough information) to accurately determine a price.
This post is a bit of an educational piece for those who wonder how VCs typically value a startup. The method I describe below, is one of the most widely used (often called the ‘VC method’). At the very least, this method provides a ballpark figure to start with, which can then be adjusted according to a variety of external factors. For more details on the VC Method, see HBS Note 9-288-006.
In describing this method I will start with a simple scenario of a company that takes only one round of venture financing, and then show how this method can be expanded to handle multi-stage financing.
Terminal Value The first thing we need to calculate is a ‘terminal value’ for the company. That is, a value at some point (say 5 years) in the future. This point may be an expected liquidity event (IPO or acquisition), or failing that should be a point where the company is at least earning a profit. We need to somehow come up with a value for the company at that point in time. The easiest way to do this is to look at a comparable company. For example, if a company in the same or similar industry was recently acquired or went public, this value can be used as a proxy for the terminal value of the company we are trying to value. Another, perhaps more common method, is to look at price/earnings (PE) ratios for companies in the industry, and use this along with expected earnings in the terminal year as shown in the business plan (suitably discounted to adjust for EEE - Entrepreneur’s Enthusiasm Error
Lets make this clearer with an example. Our company, Infelidoo, is expected to earn a $3M profit in year 5. Comparable companies in Infelidoo’s industry are trading at PE ratios of around 15. This means Infelidoo’s expected terminal value is $3M x 15 = $45M.
Note: this terminal value is best case - assuming everything goes right. We will account for the fact that everything doesnt always go right in the discount rate (see below).
The Venture Capitalist’s Required ROI Lets say our VC is ready to invest in Infelidoo and needs to value the company. The company needs $2M to get started - and in this simplified example will need no more cash over the next 5 years to reach its goal. Given the risk of this project, the VC decides she needs a 50% annual rate of return on her investment (more on determining the rate of return later).
This means in year 5 the VC’s investment must be worth (1 + 0.50)5 x $2M = $15.2M. [That's just (1 + IRR)years x Investment]
So, in year 5 the VC expects the company to be worth $45M. Her share of the company must be worth $15.2M. Thus her ownership stake in the company must be 15.2/45 = 34%.
Note: by taking a 34% stake in the company now, in exchange for $2M, the VC is valuing the company at $6M.
The Discount RateAbove we used a discount rate (rate of return) of 50%, which may have seemed somewhat arbitrary. The discount rate reflects the level of risk in the company (the higher the chance of failure, the higher the discount rate should be). The discount rate should be the sum of:
The risk-free rate
Premium for market risk
Premium for illiquidity
Premium for value added by VC (compensation)
Premium for “fudge factor” (past experience)
Figuring out the exact discount rate to use is more art than science. Some approximate guidelines for discount rates based on the stage of the company are:
Seed stage: 80%+
Startup: 50-70%
First-Stage: 40-60%
Second-Stage: 30-50%
Bridge/Mezzanine: 20-35%
Public Expectations: 15-25%
Multi-Stage Financing The above example was overly simple because we assumed a single financing was enough to take the company to the point where it became self-sustaining. In reality companies will generally take several rounds of financing, and each round dilutes the ownership of existing shareholders. Additionally, option pools need to be reserved for future employees. This affects the percentage ownership each investor will have in the terminal year, and thus we must factor this dilution into the calculations.
In essence, we calculate the ’share of the pie’ each investor must have in the terminal year, based on when they make their investment and their required discount rate (using the process outlined above in each case). Then, we take dilution into account when calculating the ownership percentage the investor must take now (current ownership %) in order to achive this terminal percentage ownership (final ownership %).
To make this conversion, use the formula:current ownership % = (final ownership %)/(retention %)
Retention refers to the amount of ownership that a VC retains, taking into account future dilution. If there are no subsequent financing rounds then the retention is 100%. If there are subsequent rounds then it is some smaller number. To calculate the retention %, add up the sizes of final percentage ownerships of subsequent investors (the size of their slice of the final pie), and subtract this from 1. E.g. if there are three investors, and their final shares of the pie must be 15%, 10% and 5% respectively, then the retention % for investor 1 is 1 - (10% + 5%) = 85%. Similarly investor 2’s retention is 95% and investor 3’s is 100%.
Note: This is further complicated in the case where an investor also participates in subsequent rounds (which is very often the case). A simple formula wont really help here, and you’ll have to model the scenario using a spreadsheet.
After adjusting for dilution, we know the ownership stake an investor must take in the company now in exchange for her investment, which implicity places a valuation on the company.
Well - I think this blog post is now long enough :) I hope this has given any interested readers an insight into the ‘VC method’ of startup valuation. The HBS case note I mentioned at the beginning contains 54 pages of details, for those interested in reading further.
Anyone from the valley will agree there is a certain buzz in the air right now - a buzz very reminiscent of the late 90s. Not only does it remind us of the good times, but also of the dangers of getting ‘caught up in the hype’. It seems everyone is all too aware of this becoming another ‘bubble’ - and everyone, including myself, seems to be cautious about valuing new startups using ‘bubble era’ metrics.
So how should one value a startup? It’s obviously a difficult question because the company typically has no revenues, few assets (apart from people and some IP), and cannot be traded in a market with enough participants (and enough information) to accurately determine a price.
This post is a bit of an educational piece for those who wonder how VCs typically value a startup. The method I describe below, is one of the most widely used (often called the ‘VC method’). At the very least, this method provides a ballpark figure to start with, which can then be adjusted according to a variety of external factors. For more details on the VC Method, see HBS Note 9-288-006.
In describing this method I will start with a simple scenario of a company that takes only one round of venture financing, and then show how this method can be expanded to handle multi-stage financing.
Terminal Value The first thing we need to calculate is a ‘terminal value’ for the company. That is, a value at some point (say 5 years) in the future. This point may be an expected liquidity event (IPO or acquisition), or failing that should be a point where the company is at least earning a profit. We need to somehow come up with a value for the company at that point in time. The easiest way to do this is to look at a comparable company. For example, if a company in the same or similar industry was recently acquired or went public, this value can be used as a proxy for the terminal value of the company we are trying to value. Another, perhaps more common method, is to look at price/earnings (PE) ratios for companies in the industry, and use this along with expected earnings in the terminal year as shown in the business plan (suitably discounted to adjust for EEE - Entrepreneur’s Enthusiasm Error
Lets make this clearer with an example. Our company, Infelidoo, is expected to earn a $3M profit in year 5. Comparable companies in Infelidoo’s industry are trading at PE ratios of around 15. This means Infelidoo’s expected terminal value is $3M x 15 = $45M.
Note: this terminal value is best case - assuming everything goes right. We will account for the fact that everything doesnt always go right in the discount rate (see below).
The Venture Capitalist’s Required ROI Lets say our VC is ready to invest in Infelidoo and needs to value the company. The company needs $2M to get started - and in this simplified example will need no more cash over the next 5 years to reach its goal. Given the risk of this project, the VC decides she needs a 50% annual rate of return on her investment (more on determining the rate of return later).
This means in year 5 the VC’s investment must be worth (1 + 0.50)5 x $2M = $15.2M. [That's just (1 + IRR)years x Investment]
So, in year 5 the VC expects the company to be worth $45M. Her share of the company must be worth $15.2M. Thus her ownership stake in the company must be 15.2/45 = 34%.
Note: by taking a 34% stake in the company now, in exchange for $2M, the VC is valuing the company at $6M.
The Discount RateAbove we used a discount rate (rate of return) of 50%, which may have seemed somewhat arbitrary. The discount rate reflects the level of risk in the company (the higher the chance of failure, the higher the discount rate should be). The discount rate should be the sum of:
The risk-free rate
Premium for market risk
Premium for illiquidity
Premium for value added by VC (compensation)
Premium for “fudge factor” (past experience)
Figuring out the exact discount rate to use is more art than science. Some approximate guidelines for discount rates based on the stage of the company are:
Seed stage: 80%+
Startup: 50-70%
First-Stage: 40-60%
Second-Stage: 30-50%
Bridge/Mezzanine: 20-35%
Public Expectations: 15-25%
Multi-Stage Financing The above example was overly simple because we assumed a single financing was enough to take the company to the point where it became self-sustaining. In reality companies will generally take several rounds of financing, and each round dilutes the ownership of existing shareholders. Additionally, option pools need to be reserved for future employees. This affects the percentage ownership each investor will have in the terminal year, and thus we must factor this dilution into the calculations.
In essence, we calculate the ’share of the pie’ each investor must have in the terminal year, based on when they make their investment and their required discount rate (using the process outlined above in each case). Then, we take dilution into account when calculating the ownership percentage the investor must take now (current ownership %) in order to achive this terminal percentage ownership (final ownership %).
To make this conversion, use the formula:current ownership % = (final ownership %)/(retention %)
Retention refers to the amount of ownership that a VC retains, taking into account future dilution. If there are no subsequent financing rounds then the retention is 100%. If there are subsequent rounds then it is some smaller number. To calculate the retention %, add up the sizes of final percentage ownerships of subsequent investors (the size of their slice of the final pie), and subtract this from 1. E.g. if there are three investors, and their final shares of the pie must be 15%, 10% and 5% respectively, then the retention % for investor 1 is 1 - (10% + 5%) = 85%. Similarly investor 2’s retention is 95% and investor 3’s is 100%.
Note: This is further complicated in the case where an investor also participates in subsequent rounds (which is very often the case). A simple formula wont really help here, and you’ll have to model the scenario using a spreadsheet.
After adjusting for dilution, we know the ownership stake an investor must take in the company now in exchange for her investment, which implicity places a valuation on the company.
Well - I think this blog post is now long enough :) I hope this has given any interested readers an insight into the ‘VC method’ of startup valuation. The HBS case note I mentioned at the beginning contains 54 pages of details, for those interested in reading further.
2009/05/13
First Quarter Venture Investments Plunge 50 Percent Nationwide
BY Bruce V. BigelowThere was a time when venture capital partners used to tell me that venture investing is unaffected by the overall economy, because it takes five to 10 years to realize returns in startup investments. In January 2008, Deepak Kamra of Menlo Park, CA-based Canaan Partners said, “Most venture-backed companies don’t have a lot of debt, so they’re not really directly affected by the credit crunch.”
Nobody’s saying that anymore.
As expected, just-released data from two surveys shows that venture investments throughout the United States plunged by 50 percent during the first three months of 2009—marking the lowest investment level in at least 11 years.
Venture capitalists invested nearly $3.9 billion nationwide during the first three months of 2009—a 50 percent decline from almost $7.8 billion that was invested during the first quarter of 2008, according to data from Dow Jones VentureSource. The survey counted just 477 deals during the first quarter, compared with 706 deals in same quarter last year. DowJones VentureSource also provided regional data for the quarter in Xconomy’s cities.
—New England venture investments declined by just 15.5 percent, a relatively strong showing compared to the broader trend nationwide. The survey showed $594.4 million was invested in 61 deals during the first quarter of 2009, compared with $703.3 million that went to 83 startups in the same quarter of 2008.
—In San Diego, venture funding collapsed in all sectors except life sciences. The Dow Jones data shows 15 companies getting $194.6 million during the first quarter of 2009, a 34 percent decline. On closer inspection, however, deals involving San Diego life sciences startups accounted for $190.6 million—nearly the entire total! Only one IT deal was reported in San Diego during the quarter, for $4 million.
—Washington state VC investments plunged almost 54 percent in the first quarter, with 22 startups getting $114.6 million. Venture investments remained divided fairly evenly, though, with life sciences getting $33.5 million and IT startups getting $59.5 million.
Retrenching was apparent in the nationwide data across almostevery front, according to the report from Dow Jones Venture Source.
—Venture investments in the IT sector plunged by 52 percent, with 231 venture-backed companies getting a total of almost $1.7 billion, the lowest level for the sector since 1997.
—Healthcare venture funding declined by 34, to $1.35 billion invested in 118 deals, the sector’s lowest level since 2003.
—Energy and utilities, which makes up much of the emerging cleantech sector, saw $189 million going to 15 companies, down 59 percent from the $457 million in 24 deals last year.
—The median deal size shrank to just under $2.5 million, down 73 percent from the $9 million median seen a year ago.
A rival survey also showed a 61 percent decline in venture investments nationwide, although different survey methods resulted in different numbers. In this survey, which was released by the National Venture Capital Association (NVCA) and PricewaterhouseCoopers, based on data from Thomson Reuters, VCs nationwide invested just $3 billion in 549 deals during the first quarter.
One of the sharpest differences the NVCA reported for the quarter was an 84 percent plunge in cleantech investments (Dow Jones cited a 59 percent downturn in “Energy and Utilities), with $154 million going to 33 deals nationwide. The NVCA said that contrasts dramatically with the first quarter of 2008, when $971 million was invested in 67 cleantech deals.
Noubar Afeyan, managing partner and CEO of Cambridge, MA-based Flagship Ventures, suggested the drop was more of a reflection on what was happening in cleantech venture funding in early 2008. “Part of what we’re seeing is the sheer degree of momentum investing, if that term applies to venture capital, happening then,” Afeyan said yesterday. In other words, “Too much money goes into too many deals, and a lot of that money went in expecting a short term pop in terms of market visibility or a buyout.”
Jessica Pasucci, a Dow Jones VentureSource analyst in Southern California, suggested that cleantech numbers also can get distorted because investments in solar and biomass deals tend to be very big. “A couple of deals in a quarter can make a huge difference when they are typically big numbers,” she said.
On a final note, the results between the DowJones VentureSource and NVCA surveys often vary, because each uses different survey methodologies and relies on different business networks to collect their data. But the differences were especially apparent this time among the biggest venture deals reported by each survey. You can see for yourself below.
Top 5 Deals of The Quarter
Dow Jones VentureSource
1) Open Range Communications, Greenwood Village, CO, $100M. Provider of broadband wireless Internet solutions. One Equity Partners.
2) A123 Systems, Watertown, MA, $69M. Manufacturer of rechargeable lithium ion batteries and battery systems. GE Capital, GE Energy Financial Services, Undisclosed investors.
3) Sangart, San Diego, CA, $50M. Developing biological compound from human hemoglobin as an “oxygen therapeutic.” Leucadia National, Individual investors.
4) Ardian, San Francisco, CA, $47M. Developing medical devices for treating hypertension. Advanced Technology Ventures, Emergent Medical Ventures.
5) Victory Pharma, San Diego, CA, $45M. Developing products for treating pain. Medtronic, Morgenthaler, Split Rock Ventures.
Top 5 Deals of The Quarter
NVCA PriceWaterhouseCoopers Thomson Reuters
1) Anacor Pharmaceuticals, Palo Alto, CA, $50M. Developing drugs to treat inflammatory and infectious disease. Aberdare Ventures, Care Capital, Rho Ventures, Venrock Associates, Undisclosed investor.
2) Ardian, Palo Alto, CA, $46.9M. Developing medical device for repairing congestive heart failure. Advanced Technology Ventures, Emergent Medical Ventures, Morgenthaler Ventures, Split Rock Partners, St. Paul Venture Capital, Two undisclosed investors.
3) SFJ Pharmaceuticals, San Francisco, $45M. Operates as a platform that brings U.S. and European drugs to Japan. Abingworth Management, Clarus Ventures.
4) Pathway Medical Technologies, Kirkland, WA, $40.2M. Developing medical devices intended for the treatment of arterial diseases. Forbion Capital Partners, Giza Venture Capital, HLM Venture Parnters, Latterell Venture Partners, Oxford Bioscience Partners, Undisclosed investor.
5) BioVex Group, Woburn, MA, $40M. Developing vaccines for cancer and chronic infectious disease. Credit Agricole Private Equity, Forbion Capital Partners, Harrris & Harris Group, Innoven Partenaires S.A., New Science Ventures, Scottish Equity Partners, Triathlon Medical Ventures.
Bruce V. Bigelow is the editor of Xconomy San Diego. You can e-mail him at bbigelow@xconomy.com or call 858-202-0492
Term Sheet series 1:Price
In general, there are only two things that venture funds really care about when doing investments: economics and control. The term "economics" refers to the end of the day return the investor will get and the terms that have direct impact on such return. The term "control" refers to mechanisms which allow the investors to either affirmatively exercise control over the business or allow the investor to veto certain decisions the company can make. If you are negotiating a deal and an investor is digging his or her feet in on a provision that doesn't affect the economics or control, they are probably blowing smoke, rather than elucidating substance.
Obviously the first term any entrepreneur is going to look at is the price. The pre-money and post-money terms are pretty easy to understand. The pre-money valuation is what the investor is valuing the company today, before investment, while the post-money valuation is simply the pre-money valuation plus the contemplated aggregate investment amount. There are two items to note within the valuation context: stock option pools and warrants.
Both the company and the investor will want to make sure the company has sufficiently reserved shares of equity to compensate and motivate its workforce. The bigger the pool the better, right? Not so fast. While a large option pool will make it less likely that the company runs out of available options, note that the size of the pool is taken into account in the valuation of the company, thereby effectively lowering the true pre-money valuation. If the investor believes that the option pool of the company should be increased, they will insist that such increase happen prior to the financing. Don't bother to try to fight this, as nearly all VCs will operate this way. It is better to just negotiate a higher pre-money valuation if the actual value gives you heartburn. Standard language looks like this:
Amount of Financing: An aggregate of $ X million, representing a __% ownership position on a fully diluted basis, including shares reserved for any employee option pool. Prior to the Closing, the Company will reserve shares of its Common Stock so that __% of its fully diluted capital stock following the issuance of its Series A Preferred is available for future issuances to directors, officers, employees and consultants.
Alternatively:
Price: $______ per share (the Original Purchase Price). The Original Purchase Price represents a fully-diluted pre-money valuation of $ __ million and a fully-diluted post money valuation of $__ million. For purposes of the above calculation and any other reference to fully-diluted in this term sheet, fully-diluted assumes the conversion of all outstanding preferred stockof the Company, the exercise of all authorized and currently existing stock options and warrants of the Company, and the increase of the Companys existing option pool by [ ] shares prior to this financing.
Recently, another term that has gained popularity among investors is warrants associated with financings. As with the stock option allocation, this is another way to back door a lower valuation for the company. Warrants as part of a venture financing - especially in an early stage investment - tend to create a lot of unnecessary complexity and accounting headaches down the road. If the issue is simply one of price, we recommend the entrepreneur negotiate for a lower pre-money valuation to try to eliminate the warrants. Occassionally, this may be at cross-purposes with existing investors who - for some reason - want to artificially inflate the valuation since the warrant value is rarely calculated as part of the valuation (but definitely impacts the future allocation of proceeds in a liquidity event.) Note, that with bridge loan financings, warrants are commonplace as the bridge investor wants to get a lower price on the conversion of their bridge into the next round - it's not worth fighting these warrants.
The best way for an entrepreneur to negotiate price is to have multiple VCs interested in investing in his company - (economics 101: If you have more demand (VCs interested) than supply (equity in your company to sell) then price will increase.) In early rounds, your new investors will likely be looking for the lowest possible price that still leaves enough equity in the founders and employees hands. In later rounds, your existing investors will often argue for the highest price for new investors in order to limit the existing investors dilution. If there are no new investors interested in investing in your company, your existing investors will often argue for an equal to (flat round) or lower than (down round) price then the previous round. Finally, new investors will always argue for the lowest price they think will enable them to get a financing done, given the appetite (or lack thereof) of the existing investors in putting more money into the company. As an entrepreneur, you are faced with all of these contradictory motivations in a financing, reinforcing the truism that it is incredibly important to pick your early investors wisely, as they can materially help or hurt this process.
Obviously the first term any entrepreneur is going to look at is the price. The pre-money and post-money terms are pretty easy to understand. The pre-money valuation is what the investor is valuing the company today, before investment, while the post-money valuation is simply the pre-money valuation plus the contemplated aggregate investment amount. There are two items to note within the valuation context: stock option pools and warrants.
Both the company and the investor will want to make sure the company has sufficiently reserved shares of equity to compensate and motivate its workforce. The bigger the pool the better, right? Not so fast. While a large option pool will make it less likely that the company runs out of available options, note that the size of the pool is taken into account in the valuation of the company, thereby effectively lowering the true pre-money valuation. If the investor believes that the option pool of the company should be increased, they will insist that such increase happen prior to the financing. Don't bother to try to fight this, as nearly all VCs will operate this way. It is better to just negotiate a higher pre-money valuation if the actual value gives you heartburn. Standard language looks like this:
Amount of Financing: An aggregate of $ X million, representing a __% ownership position on a fully diluted basis, including shares reserved for any employee option pool. Prior to the Closing, the Company will reserve shares of its Common Stock so that __% of its fully diluted capital stock following the issuance of its Series A Preferred is available for future issuances to directors, officers, employees and consultants.
Alternatively:
Price: $______ per share (the Original Purchase Price). The Original Purchase Price represents a fully-diluted pre-money valuation of $ __ million and a fully-diluted post money valuation of $__ million. For purposes of the above calculation and any other reference to fully-diluted in this term sheet, fully-diluted assumes the conversion of all outstanding preferred stockof the Company, the exercise of all authorized and currently existing stock options and warrants of the Company, and the increase of the Companys existing option pool by [ ] shares prior to this financing.
Recently, another term that has gained popularity among investors is warrants associated with financings. As with the stock option allocation, this is another way to back door a lower valuation for the company. Warrants as part of a venture financing - especially in an early stage investment - tend to create a lot of unnecessary complexity and accounting headaches down the road. If the issue is simply one of price, we recommend the entrepreneur negotiate for a lower pre-money valuation to try to eliminate the warrants. Occassionally, this may be at cross-purposes with existing investors who - for some reason - want to artificially inflate the valuation since the warrant value is rarely calculated as part of the valuation (but definitely impacts the future allocation of proceeds in a liquidity event.) Note, that with bridge loan financings, warrants are commonplace as the bridge investor wants to get a lower price on the conversion of their bridge into the next round - it's not worth fighting these warrants.
The best way for an entrepreneur to negotiate price is to have multiple VCs interested in investing in his company - (economics 101: If you have more demand (VCs interested) than supply (equity in your company to sell) then price will increase.) In early rounds, your new investors will likely be looking for the lowest possible price that still leaves enough equity in the founders and employees hands. In later rounds, your existing investors will often argue for the highest price for new investors in order to limit the existing investors dilution. If there are no new investors interested in investing in your company, your existing investors will often argue for an equal to (flat round) or lower than (down round) price then the previous round. Finally, new investors will always argue for the lowest price they think will enable them to get a financing done, given the appetite (or lack thereof) of the existing investors in putting more money into the company. As an entrepreneur, you are faced with all of these contradictory motivations in a financing, reinforcing the truism that it is incredibly important to pick your early investors wisely, as they can materially help or hurt this process.
how to design a typical VC investment structure
Venture capital is a professionally managed pool of capital that is raised from public and private pension funds, endowments, foundations, banks, insurance companies, corporations, and wealthy families and individuals. Venture capitalists ("VCs") generally invest in companies with high growth potential which have a realistic exit scenario within 5 to 7 years. A typical VC investment structure will include rights and protections that are designed to allow the VCs to gain liquidity and maximize the return for their investors.
Liquidation Rights
Most venture capital investments are structured as convertible preferred stock with dividend and liquidation preferences. The preferred stock often will bear a fixed rate dividend that, due to the cash constraints of early stage companies, is not payable currently but is cumulative and becomes part of the liquidation preference upon a sale or liquidation of the company. The payment of dividends on the preferred stock will have priority over common stock dividends. These cumulative dividend rights provide a priority minimum rate of return to the VCs.
The preferred stock will have a liquidation preference that is generally equal to the purchase price, plus accrued and unpaid dividends, to ensure that the VCs get their money back before the holders of the common stock (e.g., founders, management, and employees) if the company is sold or liquidated. Most VCs also insist on participation rights so that they share on an equal basis with the holders of the common stock in any proceeds that remain after the payment of their liquidation preference. These liquidation rights and the right to convert the preferred stock into common stock allow the VCs to share in the upside if the company is successfully sold.
An important consideration to VCs is the percentage of the company that they own on a fully-diluted basis. Fully-diluted means the total number of issued shares of common stock, plus all shares of common stock which would be issued if all outstanding options, warrants, convertible preferred stock, and convertible debt were exercised or converted. This percentage is a function of the pre-money valuation of the company upon which the VCs and the company agree. In determining the pre-money valuation, VCs analyze the projected value of the company and the percentage of this value that will provide them with their required rate of return. This analysis takes into account the risks to the company and the future dilution to the initial investors from anticipated follow-on investments.
VCs protect their ownership percentages through preemptive rights, anti-dilution protection, and price protection. Preemptive rights enable the investors to maintain their percentage ownership in the company by purchasing a pro rata share of stock sold in future financing rounds. Anti-dilution protection adjusts the investors’ ownership percentages if the company effects a stock split, stock dividend, or recapitalization. Price protection adjusts the conversion price at which the preferred stock can be converted into common stock if the company issues common stock or stock convertible into common stock at a price below the current conversion price of the preferred stock (i.e., the VCs will be issued more shares of common stock upon the conversion of the preferred stock). This protects the VCs from the risk that they overpaid for their stock if the pre-money valuation turns out to be too high.
There are two common types of price protection: full ratchet and weighted average ratchet. A full ratchet adjusts the conversion price to the lowest price at which the company subsequently sells its common stock regardless of the number of shares of common stock the company issues at that price. A weighted average ratchet adjusts the conversion price according to a formula that takes into account the lower issue price and the number of shares that the company issues at that price.
Management Participation and Control
Many VCs state that they invest in management, not technology, and VCs expect the management team to operate the business without undue interference. However, most investment structures provide that the VCs participate in management through board of directors representation, affirmative and negative covenants or protective provisions, and stock transfer restrictions. Typical protective provisions give the VCs the right to approve amendments to the company’s certificate of incorporation and bylaws, future issuances of stock, the declaration and payment of dividends, increases in the company’s stock option pool, expenditures in excess of approved budgets, the incurrence of debt, and the sale of the company. In addition, VCs generally require that management’s stock be subject to vesting and buy-back rights.
As long as the company is achieving its business goals and not violating any of the protective provisions, most VCs permit management to operate the business without substantial investor participation except at the board level. However, VCs may negotiate the right to take control of the board of directors if the company materially fails to achieve its business plan or to meet certain milestones or if the company violates any of the protective provisions.
Exit Rights
VCs must achieve liquidity in order to provide the requisite rate of return to their investors. Most VC funds have a limited life of 10 years and most investments from a fund are made in the first 4 years. Therefore, investments are structured to provide liquidity within 5 to 7 years so that investments that are made in a fund’s third and fourth years are liquidated as the fund winds up and its assets are distributed to the fund’s investors. The primary liquidity events for VCs are the sale of the company, the initial public offering of the company’s stock, or the redemption or repurchase of their stock by the company.
Generally, VCs do not have a contractual right to force the company to be sold. However, the sale of the company will be subject to the approval of the VCs, and depending upon the composition of the board of directors the VCs may be in a position to direct the sale efforts. VCs typically also have demand registration rights that theoretically give them the right to force the company to go public and register their shares. Also, VCs will generally have piggyback registration rights that give them the right to include their stock in future company registrations.
VCs also insist on put or redemption rights to achieve liquidity if it is not available through a sale or public offering. This gives the investors the right to require the company to repurchase their stock after a period of generally 4 to 7 years. The purchase price for the VCs’ stock may be based upon the liquidation preference (i.e., the purchase price, plus accrued and unpaid dividends), the fair market value of the stock as determined by an appraiser, or the value of the stock based upon a multiple of the company’s earnings. An early stage company (particularly one which is struggling) may not be able to finance the buyout of an investor and the redemption right may not be a practical way to gain liquidity. However, this right gives the VCs tremendous leverage to force management to deal with their need for an exit and can result in a forced sale of the company. Also, if the VCs trigger their redemption right and the company breaches its payment obligations, the VCs may be able to take over control of the board of directors of the company.
Other exit rights that VCs typical require are "tag along" and "drag along" rights. Tag along rights give the investors the right to include their stock in any sale of stock by management. Drag along rights give the investors the right to force management to sell their stock in any sale of stock by the investors.
Conclusion
VC investment terms may seem onerous and complex to entrepreneurs. However, by understanding the goals of the VCs, entrepreneurs, with the assistance of experienced legal counsel, will be in a better position to negotiate an investment structure that meets the goals of both the VCs and management.
Liquidation Rights
Most venture capital investments are structured as convertible preferred stock with dividend and liquidation preferences. The preferred stock often will bear a fixed rate dividend that, due to the cash constraints of early stage companies, is not payable currently but is cumulative and becomes part of the liquidation preference upon a sale or liquidation of the company. The payment of dividends on the preferred stock will have priority over common stock dividends. These cumulative dividend rights provide a priority minimum rate of return to the VCs.
The preferred stock will have a liquidation preference that is generally equal to the purchase price, plus accrued and unpaid dividends, to ensure that the VCs get their money back before the holders of the common stock (e.g., founders, management, and employees) if the company is sold or liquidated. Most VCs also insist on participation rights so that they share on an equal basis with the holders of the common stock in any proceeds that remain after the payment of their liquidation preference. These liquidation rights and the right to convert the preferred stock into common stock allow the VCs to share in the upside if the company is successfully sold.
An important consideration to VCs is the percentage of the company that they own on a fully-diluted basis. Fully-diluted means the total number of issued shares of common stock, plus all shares of common stock which would be issued if all outstanding options, warrants, convertible preferred stock, and convertible debt were exercised or converted. This percentage is a function of the pre-money valuation of the company upon which the VCs and the company agree. In determining the pre-money valuation, VCs analyze the projected value of the company and the percentage of this value that will provide them with their required rate of return. This analysis takes into account the risks to the company and the future dilution to the initial investors from anticipated follow-on investments.
VCs protect their ownership percentages through preemptive rights, anti-dilution protection, and price protection. Preemptive rights enable the investors to maintain their percentage ownership in the company by purchasing a pro rata share of stock sold in future financing rounds. Anti-dilution protection adjusts the investors’ ownership percentages if the company effects a stock split, stock dividend, or recapitalization. Price protection adjusts the conversion price at which the preferred stock can be converted into common stock if the company issues common stock or stock convertible into common stock at a price below the current conversion price of the preferred stock (i.e., the VCs will be issued more shares of common stock upon the conversion of the preferred stock). This protects the VCs from the risk that they overpaid for their stock if the pre-money valuation turns out to be too high.
There are two common types of price protection: full ratchet and weighted average ratchet. A full ratchet adjusts the conversion price to the lowest price at which the company subsequently sells its common stock regardless of the number of shares of common stock the company issues at that price. A weighted average ratchet adjusts the conversion price according to a formula that takes into account the lower issue price and the number of shares that the company issues at that price.
Management Participation and Control
Many VCs state that they invest in management, not technology, and VCs expect the management team to operate the business without undue interference. However, most investment structures provide that the VCs participate in management through board of directors representation, affirmative and negative covenants or protective provisions, and stock transfer restrictions. Typical protective provisions give the VCs the right to approve amendments to the company’s certificate of incorporation and bylaws, future issuances of stock, the declaration and payment of dividends, increases in the company’s stock option pool, expenditures in excess of approved budgets, the incurrence of debt, and the sale of the company. In addition, VCs generally require that management’s stock be subject to vesting and buy-back rights.
As long as the company is achieving its business goals and not violating any of the protective provisions, most VCs permit management to operate the business without substantial investor participation except at the board level. However, VCs may negotiate the right to take control of the board of directors if the company materially fails to achieve its business plan or to meet certain milestones or if the company violates any of the protective provisions.
Exit Rights
VCs must achieve liquidity in order to provide the requisite rate of return to their investors. Most VC funds have a limited life of 10 years and most investments from a fund are made in the first 4 years. Therefore, investments are structured to provide liquidity within 5 to 7 years so that investments that are made in a fund’s third and fourth years are liquidated as the fund winds up and its assets are distributed to the fund’s investors. The primary liquidity events for VCs are the sale of the company, the initial public offering of the company’s stock, or the redemption or repurchase of their stock by the company.
Generally, VCs do not have a contractual right to force the company to be sold. However, the sale of the company will be subject to the approval of the VCs, and depending upon the composition of the board of directors the VCs may be in a position to direct the sale efforts. VCs typically also have demand registration rights that theoretically give them the right to force the company to go public and register their shares. Also, VCs will generally have piggyback registration rights that give them the right to include their stock in future company registrations.
VCs also insist on put or redemption rights to achieve liquidity if it is not available through a sale or public offering. This gives the investors the right to require the company to repurchase their stock after a period of generally 4 to 7 years. The purchase price for the VCs’ stock may be based upon the liquidation preference (i.e., the purchase price, plus accrued and unpaid dividends), the fair market value of the stock as determined by an appraiser, or the value of the stock based upon a multiple of the company’s earnings. An early stage company (particularly one which is struggling) may not be able to finance the buyout of an investor and the redemption right may not be a practical way to gain liquidity. However, this right gives the VCs tremendous leverage to force management to deal with their need for an exit and can result in a forced sale of the company. Also, if the VCs trigger their redemption right and the company breaches its payment obligations, the VCs may be able to take over control of the board of directors of the company.
Other exit rights that VCs typical require are "tag along" and "drag along" rights. Tag along rights give the investors the right to include their stock in any sale of stock by management. Drag along rights give the investors the right to force management to sell their stock in any sale of stock by the investors.
Conclusion
VC investment terms may seem onerous and complex to entrepreneurs. However, by understanding the goals of the VCs, entrepreneurs, with the assistance of experienced legal counsel, will be in a better position to negotiate an investment structure that meets the goals of both the VCs and management.
2009/05/12
brief definitions of terminology in term sheets
You've impressed a number of venture capital firms, and now it's time to sit down face to face with these potential partners, find out what they can do for you, and discuss terms. The terms of an investment agreement are spelled out on what is called the term sheet. To help prepare you for this discussion, here are some brief definitions of terminology found in term sheets.
Negotiating the terms of the agreement is part of establishing a close working relationship with your venture partner.
Price/Valuation
Valuation is a highly contested issue between entrepreneur and venture capitalist. It’s not something you have to figure out on your own. Simply put, the value of a company is what drives the price investors will pay for a piece of the action. The information used to determine valuation comes out of the due diligence process, and has to do with the strength of the management team, market potential, the sustainable advantage of the product/service, and potential financial returns. Another way to look at valuation is how much money it will take to make the company a success. In the end, the value of a company is the price at which a willing buyer and seller can complete a transaction.
Fully Diluted
Ownership and valuation is typically calculated on a fully diluted basis. This means that all securities, including preferred stock, options and warrants, that can result in additional common shares, are counted in determining the total amount of shares outstanding for the purposes of determining ownership or valuation.
Type of Security
Investors typically receive convertible preferred stock in exchange for making the investment in a new venture. This type of stock has priority over common stock if the company is acquired or liquidated and assets are distributed. The higher priority of the preferred stock justifies a higher price, compared to the price paid by founders for common stock. "Convertible" means that the shares may be exchanged for a fixed number of common shares.
Liquidation Preference
When the company is sold or liquidated, the preferred stockholders will receive a certain fixed amount before any assets are distributed to the common stockholders. A "participating preferred" stockholder will not only receive the fixed amount, but will also share in any additional amounts distributed to common stock.
Dividend Preference
Dividends are paid first to preferred stock, and then common stock. This dividend may be cumulative – so that it accrues from year to year until paid in full, or non-cumulative and discretionary.
Redemption
Preferred stock may be redeemed or retired, either at the option of the company or the investors, or on a mandatory basis, frequently at some premium over the initial purchase price of the stock. One reason why venture firms want this right is due to the finite life of each investment partnership managed by the firm.
Conversion Rights
Preferred stock may be converted into common stock at a certain conversion price, generally whenever the stockholder chooses. Conversion may also happen automatically in response to certain events, such as when the company goes public.
Anti-dilution Protection
The conversion price of the preferred stock is subject to adjustment for certain diluting events, such as stock splits or stock dividends. The conversion price is typically subject to "price protection," which is an adjustment based on future sales of stock at prices below the conversion price. Price protection can take many forms. One form is called "ratchet" protection, which lowers the conversion price to the price at which any new stock is sold no matter the number of shares. Another form is broad-based "weighted average" protection, which adjusts the conversion price according to a formula that incorporates the number of new shares being issued, and their price. In many cases, a certain number of shares are exempted from this protection to cover anticipated assurances to key employees, consultants, and directors.
Voting Rights
Preferred stock has a number of votes equal to the number of shares of common stock into which it is convertible. Preferred stock usually has special voting rights, such as the right to elect one or more of the company’s directors, or to approve certain types of corporate actions, such as amending the articles of incorporation, or creating a new series of preferred stock.
Right of First Refusal
Holders of preferred stock typically have the right to purchase additional shares when issued by the company, up to their current aggregate ownership percentage.
Co-Sale Right
Founders will often enter into a co-sale agreement with investors. A co-sale right gives investors some protection for investors against founders selling their interest to a third party by giving investors the right to sell part of their stock as part of such a sale.
Registration Rights
Registration rights are generally given to preferred investors as part of their investment. These rights provide investors liquidity by allowing them to require the company to register their shares for sale to the public -- either as part of an offering already planned by the company (called piggyback rights), or in a separate offering initiated at the investors’ request (called demand rights).
Vesting on Founders’ Stock
A percentage of founders’ stock, which decreases over time, can be purchased by the company at cost if a founder leaves the company. This is a protection for the investors against founders leaving the company after it gets funded.
Negotiating the terms of the agreement is part of establishing a close working relationship with your venture partner.
Price/Valuation
Valuation is a highly contested issue between entrepreneur and venture capitalist. It’s not something you have to figure out on your own. Simply put, the value of a company is what drives the price investors will pay for a piece of the action. The information used to determine valuation comes out of the due diligence process, and has to do with the strength of the management team, market potential, the sustainable advantage of the product/service, and potential financial returns. Another way to look at valuation is how much money it will take to make the company a success. In the end, the value of a company is the price at which a willing buyer and seller can complete a transaction.
Fully Diluted
Ownership and valuation is typically calculated on a fully diluted basis. This means that all securities, including preferred stock, options and warrants, that can result in additional common shares, are counted in determining the total amount of shares outstanding for the purposes of determining ownership or valuation.
Type of Security
Investors typically receive convertible preferred stock in exchange for making the investment in a new venture. This type of stock has priority over common stock if the company is acquired or liquidated and assets are distributed. The higher priority of the preferred stock justifies a higher price, compared to the price paid by founders for common stock. "Convertible" means that the shares may be exchanged for a fixed number of common shares.
Liquidation Preference
When the company is sold or liquidated, the preferred stockholders will receive a certain fixed amount before any assets are distributed to the common stockholders. A "participating preferred" stockholder will not only receive the fixed amount, but will also share in any additional amounts distributed to common stock.
Dividend Preference
Dividends are paid first to preferred stock, and then common stock. This dividend may be cumulative – so that it accrues from year to year until paid in full, or non-cumulative and discretionary.
Redemption
Preferred stock may be redeemed or retired, either at the option of the company or the investors, or on a mandatory basis, frequently at some premium over the initial purchase price of the stock. One reason why venture firms want this right is due to the finite life of each investment partnership managed by the firm.
Conversion Rights
Preferred stock may be converted into common stock at a certain conversion price, generally whenever the stockholder chooses. Conversion may also happen automatically in response to certain events, such as when the company goes public.
Anti-dilution Protection
The conversion price of the preferred stock is subject to adjustment for certain diluting events, such as stock splits or stock dividends. The conversion price is typically subject to "price protection," which is an adjustment based on future sales of stock at prices below the conversion price. Price protection can take many forms. One form is called "ratchet" protection, which lowers the conversion price to the price at which any new stock is sold no matter the number of shares. Another form is broad-based "weighted average" protection, which adjusts the conversion price according to a formula that incorporates the number of new shares being issued, and their price. In many cases, a certain number of shares are exempted from this protection to cover anticipated assurances to key employees, consultants, and directors.
Voting Rights
Preferred stock has a number of votes equal to the number of shares of common stock into which it is convertible. Preferred stock usually has special voting rights, such as the right to elect one or more of the company’s directors, or to approve certain types of corporate actions, such as amending the articles of incorporation, or creating a new series of preferred stock.
Right of First Refusal
Holders of preferred stock typically have the right to purchase additional shares when issued by the company, up to their current aggregate ownership percentage.
Co-Sale Right
Founders will often enter into a co-sale agreement with investors. A co-sale right gives investors some protection for investors against founders selling their interest to a third party by giving investors the right to sell part of their stock as part of such a sale.
Registration Rights
Registration rights are generally given to preferred investors as part of their investment. These rights provide investors liquidity by allowing them to require the company to register their shares for sale to the public -- either as part of an offering already planned by the company (called piggyback rights), or in a separate offering initiated at the investors’ request (called demand rights).
Vesting on Founders’ Stock
A percentage of founders’ stock, which decreases over time, can be purchased by the company at cost if a founder leaves the company. This is a protection for the investors against founders leaving the company after it gets funded.
2009/05/10
What Venture Capital Can Learn from Private Equity
By Peter Rip
Baseball and venture capital always seem to make an effective pairing for analogies. As in baseball, much of the cachet of venture capital is inspired by the romance of the metaphoric grand slam. The recipe has been the same since venture capital began: Find a team, give it money, sit back, and wait for the bloom. Most investments fail. But a few could be big winners and make it all turn out just fine. It used to be said in this business: "You can only lose one times your money." The implication is that winners will pay back the risk many times over.
The reality is that this approach works for an ever-winnowing number of companies, and shockingly few since 2000. The median venture capital fund has seriously underperformed the Russell 2000 Index since 2000. This is a stunning reversal over the prior two decades. What happened? There was a structural change in the game, yet most of the incumbents kept executing the same playbook.
Traditionally that has meant funding disruptive change and managing execution risk. For example, the decision by Kleiner Perkins Caufield & Byers to recruit Eric Schmidt was a masterful way to take the risk out of business execution at Google (GOOG) early on. Closer to my home, my partner, Jim Feuille, led change in our business model when we invested in Pandora Media, changing from a subscription service to free personalized Internet radio. Today, Pandora is the largest radio site on the Web. Managing execution risk at Pandora meant adding measured risk to capture the return of a bigger opportunity.
The classic VC play has always been to take enough risks and you'll be rewarded with the Great Exit, such as a big IPO or acquisition. VCs learned to excel at team selection and the mitigation of execution risk, often considering other risks inherently uncontrollable. Venture capitalists tended to place less emphasis on issues such as valuation, the timing of exits, and future capital availability precisely because you could only lose one times your money.
The Bull Benefit
Great Exits happened from 1982 to 2000 with a regular cadence. The strategy of going for the grand slam in every deal in every portfolio worked often enough during that bull market. The bull market gave public companies more currency to buy startups and often instilled public investors with confidence in the future of small growth companies. There were some spectacular successes among many long-forgotten failures.
The bull market in technology ended with a bang in 2000. Nevertheless, most of the venture capital industry still executes the same playbook, ignoring the public market, which is why the industry has performed so poorly since 2000.
Author Michael Lewis chronicled the success of baseball teams such as the 2002 Oakland Athletics in his book Moneyball. The A's didn't have the funds to buy top athletes, but instead assembled a winning team through a more analytical approach. Statistical analyses included in the book found that ballclubs that simply tried to get a man on base as many times as possible won more games than teams that focused on hitting home runs.
Most investors in venture capital understand that you cannot generate an acceptable rate of return by hitting singles and doubles. What they don't appreciate is that a strikeout is far more destructive when grand slams are fewer and further between. And with fewer grand slams, time also matters. In a secular bear market, that Great Exit may take so long to occur that the drought destroys your internal rate of return.
More Risk to Manage
In short, it has become clear since 2000 that financial risk/return is as important as execution risk in venture capital. Financial risk/return refers to weighing the risk that the financial markets may not be ripe enough soon enough to justify investing this much, at this valuation, now. Today's VCs have to pick great markets, great teams, and manage execution risk, as they always did. But they also have to manage valuation risk, timing risk, and investor syndicate risk.
Venture capitalists can learn a lot about managing this new set of risks from their counterparts in private equity. Whereas the traditional venture capital playbook has been about company-building, the private equity playbook has been about financial engineering. Private equity is focused on metrics, comparables, terms, and cost of capital—more so than innovation, market selection, and team development. Their teams and companies are more mature, reducing the need to be an expert in assessing execution risk.
Think about this in terms of an inflection point, or that period when an additional dollar invested yields far greater shareholder value than it would have at an earlier phase. It's the point at which a little gas fuels a huge fire. Finding the best companies and investing in them at inflection points are perhaps their two most important disciplines. Stage is not a consideration. It is all about that inflection point.
Venture capital is at the intersection of innovation and finance. Fortunately for investors, innovation continues without regard for the financial markets. The jet engine, the helicopter, FM broadcasting, fiberglass, nylon, photocopying, radar, sticky tape, and instant film were all invented during the Great Depression. Breakthroughs are everywhere today, in energy technology, biotechnology, and even information technology. These innovations will continue to disrupt incumbents and create new markets—and they will all need early-stage venture capital.
But the absence of buoyancy in capital markets means the early bet is not always the best bet. The new venture capital playbook begins by taking into account the macro drivers of growth. Which sectors are most ripe for disruption through innovation? Add to this the venture practice of building networks of entrepreneurs and partners who can place you in the flow of that innovation.
Inflection Points
Here's where the private equity model takes hold. Like private equity investors, VCs need to understand the entire sector, at every stage in the spectrum—seedlings through large public companies—to develop a theory of how the industry will evolve. Who will win and who will lose? When will incumbents need to make strategic acquisitions? What events have to transpire to enable big, new markets?
And, like other forms of private equity, the timing and probability of exits are as critical as their magnitude. This necessarily leads to a view toward finding inflection points, regardless of stage. Sometimes the best stage is the napkin sketch in the coffee shop; sometimes it's the phoenix rising from the ashes of $100 milllion of previous investors' capital. Either has the potential for venture capital success. The best performing venture capital investors will be able to find both.
At Crosslink Capital we have been evolving this new venture capital playbook since the late 1990s. We recognized early on that the bull market was over in 2000. We mostly sat on the sidelines for much of 2001 and 2002 with our 2000 venture fund. When we did return to investing, we did many restarts, turnarounds, and private investments in recently public companies, many of which were in Internet and services. This strategy of selectivity, stage independence, and a focus on companies at inflection has served us well.
Letting Go of the IPO Window
By 2006 we began to see two important shifts with our new venture fund. One was the emergence of energy technology as a new and important growth market opportunity. Many energy technologies had reached a point where the scientific risk was being replaced with commercialization risk. This transition is always a tipping point in the emergence of new growth venture markets.
The other shift was a rising inflation in later-stage valuations. It seemed many of our peers anticipated a forthcoming IPO window, whereas we did not. So we tended to find better values in earlier-stage opportunities, where the return multiples would justify the higher financial and execution risk. A few of these companies have had very attractive subsequent financings, suggesting we are off to a very good start. Among the companies funded were Twin Creeks Technologies (energy), Like.com (search), and OpSource (cloud computing).
There are lots of strategies for playing to win in baseball and in venture capital. The best strategies are context-specific. Entrepreneurship and innovation are eternal. A few venture firms will be able to continue to successfully swing for the fences without the bull market tailwind. Most will not. Great returns will continue in venture capital, but only for those who can successfully operate across the spectrum of private companies and find great value regardless of their stage.
Rip is a general partner at Crosslink Capital, a multistage technology venture capital and growth equity firm with more than $1.4 billion in capital under management.
Baseball and venture capital always seem to make an effective pairing for analogies. As in baseball, much of the cachet of venture capital is inspired by the romance of the metaphoric grand slam. The recipe has been the same since venture capital began: Find a team, give it money, sit back, and wait for the bloom. Most investments fail. But a few could be big winners and make it all turn out just fine. It used to be said in this business: "You can only lose one times your money." The implication is that winners will pay back the risk many times over.
The reality is that this approach works for an ever-winnowing number of companies, and shockingly few since 2000. The median venture capital fund has seriously underperformed the Russell 2000 Index since 2000. This is a stunning reversal over the prior two decades. What happened? There was a structural change in the game, yet most of the incumbents kept executing the same playbook.
Traditionally that has meant funding disruptive change and managing execution risk. For example, the decision by Kleiner Perkins Caufield & Byers to recruit Eric Schmidt was a masterful way to take the risk out of business execution at Google (GOOG) early on. Closer to my home, my partner, Jim Feuille, led change in our business model when we invested in Pandora Media, changing from a subscription service to free personalized Internet radio. Today, Pandora is the largest radio site on the Web. Managing execution risk at Pandora meant adding measured risk to capture the return of a bigger opportunity.
The classic VC play has always been to take enough risks and you'll be rewarded with the Great Exit, such as a big IPO or acquisition. VCs learned to excel at team selection and the mitigation of execution risk, often considering other risks inherently uncontrollable. Venture capitalists tended to place less emphasis on issues such as valuation, the timing of exits, and future capital availability precisely because you could only lose one times your money.
The Bull Benefit
Great Exits happened from 1982 to 2000 with a regular cadence. The strategy of going for the grand slam in every deal in every portfolio worked often enough during that bull market. The bull market gave public companies more currency to buy startups and often instilled public investors with confidence in the future of small growth companies. There were some spectacular successes among many long-forgotten failures.
The bull market in technology ended with a bang in 2000. Nevertheless, most of the venture capital industry still executes the same playbook, ignoring the public market, which is why the industry has performed so poorly since 2000.
Author Michael Lewis chronicled the success of baseball teams such as the 2002 Oakland Athletics in his book Moneyball. The A's didn't have the funds to buy top athletes, but instead assembled a winning team through a more analytical approach. Statistical analyses included in the book found that ballclubs that simply tried to get a man on base as many times as possible won more games than teams that focused on hitting home runs.
Most investors in venture capital understand that you cannot generate an acceptable rate of return by hitting singles and doubles. What they don't appreciate is that a strikeout is far more destructive when grand slams are fewer and further between. And with fewer grand slams, time also matters. In a secular bear market, that Great Exit may take so long to occur that the drought destroys your internal rate of return.
More Risk to Manage
In short, it has become clear since 2000 that financial risk/return is as important as execution risk in venture capital. Financial risk/return refers to weighing the risk that the financial markets may not be ripe enough soon enough to justify investing this much, at this valuation, now. Today's VCs have to pick great markets, great teams, and manage execution risk, as they always did. But they also have to manage valuation risk, timing risk, and investor syndicate risk.
Venture capitalists can learn a lot about managing this new set of risks from their counterparts in private equity. Whereas the traditional venture capital playbook has been about company-building, the private equity playbook has been about financial engineering. Private equity is focused on metrics, comparables, terms, and cost of capital—more so than innovation, market selection, and team development. Their teams and companies are more mature, reducing the need to be an expert in assessing execution risk.
Think about this in terms of an inflection point, or that period when an additional dollar invested yields far greater shareholder value than it would have at an earlier phase. It's the point at which a little gas fuels a huge fire. Finding the best companies and investing in them at inflection points are perhaps their two most important disciplines. Stage is not a consideration. It is all about that inflection point.
Venture capital is at the intersection of innovation and finance. Fortunately for investors, innovation continues without regard for the financial markets. The jet engine, the helicopter, FM broadcasting, fiberglass, nylon, photocopying, radar, sticky tape, and instant film were all invented during the Great Depression. Breakthroughs are everywhere today, in energy technology, biotechnology, and even information technology. These innovations will continue to disrupt incumbents and create new markets—and they will all need early-stage venture capital.
But the absence of buoyancy in capital markets means the early bet is not always the best bet. The new venture capital playbook begins by taking into account the macro drivers of growth. Which sectors are most ripe for disruption through innovation? Add to this the venture practice of building networks of entrepreneurs and partners who can place you in the flow of that innovation.
Inflection Points
Here's where the private equity model takes hold. Like private equity investors, VCs need to understand the entire sector, at every stage in the spectrum—seedlings through large public companies—to develop a theory of how the industry will evolve. Who will win and who will lose? When will incumbents need to make strategic acquisitions? What events have to transpire to enable big, new markets?
And, like other forms of private equity, the timing and probability of exits are as critical as their magnitude. This necessarily leads to a view toward finding inflection points, regardless of stage. Sometimes the best stage is the napkin sketch in the coffee shop; sometimes it's the phoenix rising from the ashes of $100 milllion of previous investors' capital. Either has the potential for venture capital success. The best performing venture capital investors will be able to find both.
At Crosslink Capital we have been evolving this new venture capital playbook since the late 1990s. We recognized early on that the bull market was over in 2000. We mostly sat on the sidelines for much of 2001 and 2002 with our 2000 venture fund. When we did return to investing, we did many restarts, turnarounds, and private investments in recently public companies, many of which were in Internet and services. This strategy of selectivity, stage independence, and a focus on companies at inflection has served us well.
Letting Go of the IPO Window
By 2006 we began to see two important shifts with our new venture fund. One was the emergence of energy technology as a new and important growth market opportunity. Many energy technologies had reached a point where the scientific risk was being replaced with commercialization risk. This transition is always a tipping point in the emergence of new growth venture markets.
The other shift was a rising inflation in later-stage valuations. It seemed many of our peers anticipated a forthcoming IPO window, whereas we did not. So we tended to find better values in earlier-stage opportunities, where the return multiples would justify the higher financial and execution risk. A few of these companies have had very attractive subsequent financings, suggesting we are off to a very good start. Among the companies funded were Twin Creeks Technologies (energy), Like.com (search), and OpSource (cloud computing).
There are lots of strategies for playing to win in baseball and in venture capital. The best strategies are context-specific. Entrepreneurship and innovation are eternal. A few venture firms will be able to continue to successfully swing for the fences without the bull market tailwind. Most will not. Great returns will continue in venture capital, but only for those who can successfully operate across the spectrum of private companies and find great value regardless of their stage.
Rip is a general partner at Crosslink Capital, a multistage technology venture capital and growth equity firm with more than $1.4 billion in capital under management.
The Venture Capital Math Problem
by Fred Wilson
Yesterday Albert and I visited one of the investors in our fund. The good news is they are happy with the job we are doing. The bad news is they are frustrated with the venture capital asset class.
We got to talking about the venture capital asset class and it wasn't long before we got to the "math problem". The venture capital math problem is pretty basic, maybe something you'd do in high school calculus or even pre-calculus. Here's how it works.
The venture industry has been raising between $20bn and $30bn per year for the past few years. Here's recent data from the NVCA's web site.
Let's be generous and say that the average is $25bn per year (it's actually more). The math problem is to figure out how much in proceeds every year need to be generated to deliver a reasonable return to the investors.
Here's how I go about solving it. My math is not perfect and I'd like to hear from all of you how you'd solve it in the comments.
First, the money needs to generate 2.5x net of fees and carry to the investors to deliver a decent return. Fees and carry bump that number to 3x gross returns. So $25bn needs to turn into $75bn per year in proceeds to the venture funds.
Then you need to figure out how much of the companies the VCs normally own. The number bandied about by most VCs is 20%. That means that each VC investor owns, on average 20% of each portfolio company. We'll use that number but to be honest I think it's lower, like 15% which makes the math even tougher.
Using the 20% number, that $75bn per year must come from exits producing $375bn in total value.
But it is also true that many of these exits have multiple VC investors in them, sometimes three or four. So you really need to look at the percent ownership by VC funds in the average deal at the time of exit. That number is likely to be over 50% and maybe as high as 60%. If we use 50%, then to get $75bn per year in distributions, we need to get $150bn per year in exits.
Here's where my math starts to get a little fuzzy and where I'd love some other approaches. I assume that the distributions of exits each year is distributed on a power law curve like this one:
I've heard from investors in venture funds, including the one we visited with yesterday, that about 200 exits per year produce all the returns in the business. I think that number is too low because that is about the number of venture funds raised each year. That would suggest each fund has only one meaningful exit and that's just not right. I think each fund has at least five or six meaningful exits. So I would use a number like 1000 exits per year.
And I assume that the biggest exit each year is $5bn. Yes, it is true that some venture investments turn into businesses like Apple, Google, Microsoft that are worth $100bn and more. But it is also true that most VCs are long gone from those deals before the valuations get to that level. So for the sake of solving this problem, I'd assume the largest exit each year is $5bn and then you have a power law distribution of another 999 deals.
These assumptions are important to the results you get from this math problem and I'd love to hear everyone's thoughts on them in the comments.
I tweeted this power law math problem yesterday hoping to get some answers. Most of the replies said that I need a "scaling exponent" or a "power number" to get the answer I wanted. So my attempt to use twitter as a math crutch didn't work out very well.
So in order to finish this post and get to a discussion, I'll assume that the biggest deal, $5bn, represents 5% of the total value of all 1000 exits and that the total value of all exits is $100bn per year. If others come up with different numbers I will update this post with them here.
So here's the venture capital math problem. We need $150bn per year in exits and we are getting about $100bn. That $100bn produces roughly $50bn in proceeds for venture firms per year. After fees and carry, that $50bn is around $40bn. Which is only 1.6x on the investor's capital if $25bn per year is going into venture funds. If you assume the investors capital is tied up for an average of 5 years (venture funds call capital over a five year period and distribute it back over a five year period, on average), then the annual return is around 10%.
Here are the most recent NVCA numbers which I got from Anthony Ha's Venturebeat piece a few days ago:
I tend to look at 5 year and 10 year numbers since 20 year numbers include a period when there was a lot less money in the venture business. Those numbers suggest that the 10% per year returns are about right, or are at least in the ballpark.
So here's my conclusions from all of this math (some good, some not so good). The venture capital asset class does not scale. You cannot invest $25bn per year and generate the kinds of returns investors seek from the asset class. If $100bn per year in exits is a steady state number, then we need to work back from that and determine how much the asset class can manage.
If you use my 3x gross and on average 50% ownership by VCs, then the number that the asset class can take on each year is around $15bn to $17bn. It's interesting to note that the industry raised $4.3bn in the first quarter of 2009. That's a good thing. If we can keep it to that level, or less for a while, then we may be able to downsize and get returns back on track.
I'm optimistic that it will happen. In an open and free market, capital will flow to the places where it can earn an appropriate return. I suspect we'll see some of the large public pension funds who have been drawn to venture capital over the past decade decide to leave the asset class because it does not scale to the levels they need to efficiently invest capital. That will leave the asset class to family offices, endowments, and other smaller institutions who made up the largest part of the asset class in the 1980s and early 1990s.
I think "back to the future" is the answer to most of the venture capital asset class problems. Less capital in the asset class, smaller fund sizes, smaller partnerships, smaller deals, and smaller exits. The math works as long as you don't put too many zeros on the end of the numbers you are working with.
Yesterday Albert and I visited one of the investors in our fund. The good news is they are happy with the job we are doing. The bad news is they are frustrated with the venture capital asset class.
We got to talking about the venture capital asset class and it wasn't long before we got to the "math problem". The venture capital math problem is pretty basic, maybe something you'd do in high school calculus or even pre-calculus. Here's how it works.
The venture industry has been raising between $20bn and $30bn per year for the past few years. Here's recent data from the NVCA's web site.
Let's be generous and say that the average is $25bn per year (it's actually more). The math problem is to figure out how much in proceeds every year need to be generated to deliver a reasonable return to the investors.
Here's how I go about solving it. My math is not perfect and I'd like to hear from all of you how you'd solve it in the comments.
First, the money needs to generate 2.5x net of fees and carry to the investors to deliver a decent return. Fees and carry bump that number to 3x gross returns. So $25bn needs to turn into $75bn per year in proceeds to the venture funds.
Then you need to figure out how much of the companies the VCs normally own. The number bandied about by most VCs is 20%. That means that each VC investor owns, on average 20% of each portfolio company. We'll use that number but to be honest I think it's lower, like 15% which makes the math even tougher.
Using the 20% number, that $75bn per year must come from exits producing $375bn in total value.
But it is also true that many of these exits have multiple VC investors in them, sometimes three or four. So you really need to look at the percent ownership by VC funds in the average deal at the time of exit. That number is likely to be over 50% and maybe as high as 60%. If we use 50%, then to get $75bn per year in distributions, we need to get $150bn per year in exits.
Here's where my math starts to get a little fuzzy and where I'd love some other approaches. I assume that the distributions of exits each year is distributed on a power law curve like this one:
I've heard from investors in venture funds, including the one we visited with yesterday, that about 200 exits per year produce all the returns in the business. I think that number is too low because that is about the number of venture funds raised each year. That would suggest each fund has only one meaningful exit and that's just not right. I think each fund has at least five or six meaningful exits. So I would use a number like 1000 exits per year.
And I assume that the biggest exit each year is $5bn. Yes, it is true that some venture investments turn into businesses like Apple, Google, Microsoft that are worth $100bn and more. But it is also true that most VCs are long gone from those deals before the valuations get to that level. So for the sake of solving this problem, I'd assume the largest exit each year is $5bn and then you have a power law distribution of another 999 deals.
These assumptions are important to the results you get from this math problem and I'd love to hear everyone's thoughts on them in the comments.
I tweeted this power law math problem yesterday hoping to get some answers. Most of the replies said that I need a "scaling exponent" or a "power number" to get the answer I wanted. So my attempt to use twitter as a math crutch didn't work out very well.
So in order to finish this post and get to a discussion, I'll assume that the biggest deal, $5bn, represents 5% of the total value of all 1000 exits and that the total value of all exits is $100bn per year. If others come up with different numbers I will update this post with them here.
So here's the venture capital math problem. We need $150bn per year in exits and we are getting about $100bn. That $100bn produces roughly $50bn in proceeds for venture firms per year. After fees and carry, that $50bn is around $40bn. Which is only 1.6x on the investor's capital if $25bn per year is going into venture funds. If you assume the investors capital is tied up for an average of 5 years (venture funds call capital over a five year period and distribute it back over a five year period, on average), then the annual return is around 10%.
Here are the most recent NVCA numbers which I got from Anthony Ha's Venturebeat piece a few days ago:
I tend to look at 5 year and 10 year numbers since 20 year numbers include a period when there was a lot less money in the venture business. Those numbers suggest that the 10% per year returns are about right, or are at least in the ballpark.
So here's my conclusions from all of this math (some good, some not so good). The venture capital asset class does not scale. You cannot invest $25bn per year and generate the kinds of returns investors seek from the asset class. If $100bn per year in exits is a steady state number, then we need to work back from that and determine how much the asset class can manage.
If you use my 3x gross and on average 50% ownership by VCs, then the number that the asset class can take on each year is around $15bn to $17bn. It's interesting to note that the industry raised $4.3bn in the first quarter of 2009. That's a good thing. If we can keep it to that level, or less for a while, then we may be able to downsize and get returns back on track.
I'm optimistic that it will happen. In an open and free market, capital will flow to the places where it can earn an appropriate return. I suspect we'll see some of the large public pension funds who have been drawn to venture capital over the past decade decide to leave the asset class because it does not scale to the levels they need to efficiently invest capital. That will leave the asset class to family offices, endowments, and other smaller institutions who made up the largest part of the asset class in the 1980s and early 1990s.
I think "back to the future" is the answer to most of the venture capital asset class problems. Less capital in the asset class, smaller fund sizes, smaller partnerships, smaller deals, and smaller exits. The math works as long as you don't put too many zeros on the end of the numbers you are working with.
2009/05/09
How to get a job in venture capital
A few years ago I wrote a post on how to get a job in venture capital. It was lucky enough to get broad distribution and remains my most viewed and linked to post. I've had a number of questions about it over the years and have tried to respond to people who wrote in to ask my opinion about their VC job search. One of the most common questions I've received runs something like: "I get it - finding a venture job is hard. I still really want to try and I have a 5+ year outlook on this. What should I do during that time to work towards my goal of landing a venture job?"
Of course the real answer depends a lot on the individual asking - where they are in their career and life, where they live, what their educational and work background is, etc. That said, let me try to provide a few ideas.
Go to business school. As much as it pains me to say it the fact is that it's a lot easier to get a job in venture capital if you have a degree from a top business school (pains me not because I don't have many VC friends who attended such schools, but because I have many that have not, and I don't personally feel not having a degree from Harvard should be such a barrier to obtaining a venture job). While there are a lot of reasons to go to all sorts of different business schools and while many very successful venture capitalists have either never been to b-school or didn't attend a top 10 school - if you're intent in attending school is to land a job in VC you are MUCH better off going to a top school. MUCH. I know of several firms that simply won't even consider associate candidates that haven't attended a very short list of top chools (Harvard, Stanford and a few others). In fact, going to a non-top 10 business school could actually hurt your chances vs. not going at all. Not fair, I know (and I didn't attend b-school at all, so who am I to even suggest this) but true.
Work for a start-up. This may seem obvious, but almost no matter what your background if you're trying to build a resume to land in VC, having start-up experience is extremely helpful (preferably from a start-up that ends up well). As a practical matter, it's helpful to have this experience as a VC - it will give you insight on what works and what doesn't in the start-up world; will test whether you really like start-up environment and potentially expose you to venture finance and other areas of company formation and growth that will serve as a helpful backdrop to your venture career. In addition, if your company has institutional investors, you will hopefully get the opportunity to spend some time with your would-be peers which may help jump-start your eventual search (make that happen - its one of the key reasons you took the job working for a start-up in the first place!).
Start a company of your own. If you can't find a start-up you're excited enough about to join, why not start one of your own? Many successful venture capitalists have started their own companies. Its a great way to gain operating experience, test out your technology ideas and, of course, meet venture capitalists.
If you're early in your career (and/or have the inclination), work for a bank or consulting firm. Like going to a top business school, having banking or consulting on your resume is an indicator to potential venture employers that you're smart, aggressive, willing to work hard and well trained. Having been a banker myself at the start of my career I'm not entirely sure these adjectives always apply, but there is clearly a bias in the world of finance towards these types of jobs as training grounds. It will also bring you into contact with people who are likely to have networks that include venture capitalists as well as potentially up your chances of getting into a top school (see the first point above). This is especially true if you're thinking of later stage venture or private equity who - much more so than early stage venture - tend to look kindly on the training one gets in these jobs.
Put yourself out there. Union Square Ventures famously asks potential applicants not to send in a traditional resume, but instead to point to the applicant's various activities around the web (their blog, articles they've authored, companies they are helping out with, etc). While this may be an extreme example of a firm valuing the online presence of potential colleagues (and one that has worked very well for the firm), having a visible profile online that you can reference and point to will be helpful in many a VC job search (especially so if the firms you are seeking employment from invest in these areas, as USV does). Your online activity can and should extend to reading and sometimes (thoughtfully) commenting on the blogs of the now vast list of VCs that write a blog. These sorts of interactions are just one way to start to engage in a conversation with people in the industry you might one day work with.
Of course the real answer depends a lot on the individual asking - where they are in their career and life, where they live, what their educational and work background is, etc. That said, let me try to provide a few ideas.
Go to business school. As much as it pains me to say it the fact is that it's a lot easier to get a job in venture capital if you have a degree from a top business school (pains me not because I don't have many VC friends who attended such schools, but because I have many that have not, and I don't personally feel not having a degree from Harvard should be such a barrier to obtaining a venture job). While there are a lot of reasons to go to all sorts of different business schools and while many very successful venture capitalists have either never been to b-school or didn't attend a top 10 school - if you're intent in attending school is to land a job in VC you are MUCH better off going to a top school. MUCH. I know of several firms that simply won't even consider associate candidates that haven't attended a very short list of top chools (Harvard, Stanford and a few others). In fact, going to a non-top 10 business school could actually hurt your chances vs. not going at all. Not fair, I know (and I didn't attend b-school at all, so who am I to even suggest this) but true.
Work for a start-up. This may seem obvious, but almost no matter what your background if you're trying to build a resume to land in VC, having start-up experience is extremely helpful (preferably from a start-up that ends up well). As a practical matter, it's helpful to have this experience as a VC - it will give you insight on what works and what doesn't in the start-up world; will test whether you really like start-up environment and potentially expose you to venture finance and other areas of company formation and growth that will serve as a helpful backdrop to your venture career. In addition, if your company has institutional investors, you will hopefully get the opportunity to spend some time with your would-be peers which may help jump-start your eventual search (make that happen - its one of the key reasons you took the job working for a start-up in the first place!).
Start a company of your own. If you can't find a start-up you're excited enough about to join, why not start one of your own? Many successful venture capitalists have started their own companies. Its a great way to gain operating experience, test out your technology ideas and, of course, meet venture capitalists.
If you're early in your career (and/or have the inclination), work for a bank or consulting firm. Like going to a top business school, having banking or consulting on your resume is an indicator to potential venture employers that you're smart, aggressive, willing to work hard and well trained. Having been a banker myself at the start of my career I'm not entirely sure these adjectives always apply, but there is clearly a bias in the world of finance towards these types of jobs as training grounds. It will also bring you into contact with people who are likely to have networks that include venture capitalists as well as potentially up your chances of getting into a top school (see the first point above). This is especially true if you're thinking of later stage venture or private equity who - much more so than early stage venture - tend to look kindly on the training one gets in these jobs.
Put yourself out there. Union Square Ventures famously asks potential applicants not to send in a traditional resume, but instead to point to the applicant's various activities around the web (their blog, articles they've authored, companies they are helping out with, etc). While this may be an extreme example of a firm valuing the online presence of potential colleagues (and one that has worked very well for the firm), having a visible profile online that you can reference and point to will be helpful in many a VC job search (especially so if the firms you are seeking employment from invest in these areas, as USV does). Your online activity can and should extend to reading and sometimes (thoughtfully) commenting on the blogs of the now vast list of VCs that write a blog. These sorts of interactions are just one way to start to engage in a conversation with people in the industry you might one day work with.
appendix:How to become a venture capitalist
I get asked this question a lot and while the real answer is “I have absolutely no idea,” I thought I’d make something up here so I at least have a place to send people who ask me this question (as well as anyone else who happens to stumble upon this blog searching for ‘getting a job at a venture capital firm’). This post is for aspiring analysts, associates and principals and has little to do with getting a job as a partner (which I hope to figure out one day too . . .)
Step one: Assume you will not be able to land a job as a venture capitalist. This is the realistic outcome of trying to get a job as a VC. I imagine the market is a little bit better in places like Palo Alto, but here in Denver I can count on one hand the number of VC jobs that have opened up since I joined Mobius in 2001. Only a couple (I’m thinking about 2 at the moment, but there may be a few others) actually went to people who weren’t already in the industry. Even in larger VC markets (specifically the Bay Area and Boston) there are many more people who are actively looking to get into the VC world than there are positions open.
Step two: Understand the math. It’s critical to understand how VC’s make money and therefore the fundamental request you are making when asking for a job as a VC. Venture capitalists make money in two ways – from management fees (a percentage of funds under management) and from carry (a percentage of the return on investment). The partners of the fund use the management fee to pay the expenses of running the business (office space, technical infrastructure, travel, support, etc.) and then pay themselves with what’s left over. As a non-partner you are fundamentally a cost center. The partners are quite literally taking money out of their own pockets and giving it to you. Rationally, they will only do this for one of two reasons – either you are significantly impacting their lives in a positive way that makes the trade-off worthwhile for them (you cost less than the marginal life benefit they get from having you around) and/or you will help create more carry (i.e., they can manage more deals with you around and therefore deploy more capital; you have a skill set that will positively affects the portfolio, etc.). If you fail to do these things you are just eating up management fees. There is a grey area here for Principals (called VP’s or SVP’s at some shops, junior partners at others) who are managing their own deals as well as supporting partners’ deals.
Step three: Get close to VC’s. The road to becoming a VC follows many different paths, but fundamentally your first step in landing a VC gig is likely to be figuring out who the VCs are in your area and trying to get close to them. If you’re still in college, consider a job in an investment bank or other financial services firm (even VC analyst jobs are hard to come by straight out of college – VCs tend to hire people with at least some financial training at those levels) to get the best possible training for an entry level job in VC. If you are in business school, look for internships that will allow you to meet venture capitalists (either at a VC directly or for a portfolio company of a VC). If you don’t fit any of those categories, take a job at a company backed by venture money and try to get exposure to the venture capitalists on the company’s board. In short do what you can to get to know VCs in your area so that when a position opens up you can be both top of mind and a known commodity. Take a longer term view of your approach and remember that many VCs got there not by following a traditional path (banking --> b-school --> VC) but have years of operating experience, were entrepreneurs themselves, or were somehow else involved in the business of building and growing companies.
Step four. Be smart about networking. I’m writing a separate post on the subject of smart networking, but suffice it to say here that you should put some thought in how you use your network to meet VCs. Figure out who you know who also knows VCs that you’d like to meet and play the network game as best you can. It can take a long long time to get meetings set up – be patient about it (Brad probably doesn’t remember this, but when I was first introduced to him in what was a very ‘hot’ introduction from someone who he trusted a lot and who had worked very closely with me, it took three months to actually get in to see him
Step five: Don’t get discouraged. If you remember back to step one, you weren’t going to be successful getting a job in VC in the first place, so all the progress you are making is gravy, right?!?
by seth levine
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