Ask the Wizard

A brieft post! The first and possibly the last. I and Chicago-based technology entrepreneur and investor Dan Malven got into an email discussion a few months ago after my financing term sheet post on liquidation preferences. Dan has created a very cool spreadsheet that first-time entrepreneurs can use to understand how participation, preference multiples, and even participation caps will affect distributions and ownership post-money and on exit. Dan's one of those excel masters who has awesome spreadsheet voodoo skills, and this is a very cool document. Be sure to read Dan's post that points to his worksheet.

Posted by Dick at 01:22 PM | Permalink | Comments (0) | TrackBacks (0)

A Wizard reader writes (or I should say "wrote", as this came in almost a month ago):

“My product is almost ready to go, it will make money in the early going as the model is pretty straightforward, but we need to raise money in order to scale the business. There are three of us right now. How much money should we raise in an A round, how long should we expect that to last, how long will investors expect it to last, and so on and so forth?”

Well, the obvious answer is that it all depends, but on the grounds most people would find that unhelpful, I’ll pretend it doesn’t all depend and address a few specifics.

First, let’s address the hypothesis that the company will make money soon after launch. Irrespective of whether we’re talking about profits or just top-line revenue here, I would caution that it almost always takes longer to ramp your top-line than you think it will. Everybody walks into a venture pitch with their three year financial projections that have a lousy first year, a strong second year, and a monster third year. The truth is that even most ultimately successful tech startups have a slow first year, a slow second year, and then you get your spectrum of third year results ranging from really-taking-off to continued-doldrums. It just always takes longer than you think to launch, grow, ramp sales, close deals, etc.

That’s a good segue for the rest of the question – how much to raise and how long should you expect the money to last. Everybody has different thoughts on this subject, but I would say there are two helpful guidelines. First, raise enough money to last about a year or a good six months after your next big milestone. Some people like to say “raise just enough to get you to and then you will be able to do a B round at a bigger valuation”, etc., but you want to give yourself some reasonable stretch of time to be product and strategy focused after the A round before you have to hit the road again to raise more money. It’s no fun having to think about starting to raise money again only a few weeks on the heels of closing the previous round. Second, you always need more money than you think you need, especially if this is your first startup. You can have a nice detailed spreadsheet that accurately reflects market salaries, rent, and more, but you will still require more money than you think.

Those of you reading Marc Andreessen’s excellent blog will note that my advice is out of step with his advice to “raise as much as you can”. Now, Marc has co-founded a couple of hugely successful public companies and has invested in countless others and his latest post has the words "my company" and "billion dollars" in the title, so if you find yourself wondering whether you should put more credence in his words or mine, I will repeatedly point you in his direction (you start one monster company, maybe you were lucky, maybe you were in the right place at the right time. You found two billion dollar companies? You officially know what the hell you are doing. Nobody is that lucky.) Nonetheless, I’ll disagree with him on the funding amount question, especially for first time entrepreneurs, for a couple of reasons. Now, if you’re Marc or somebody like him, I don’t disagree that you should raise as much as you can on your first institutional round. Marc isn’t getting involved in a new company hoping he can eventually exit for $60 million dollars, that’s just not an interesting scale to somebody that’s created a couple companies worth well over a billion dollars. I also realize the astute first time entrepreneur in my audience is thinking “but I’m not looking to sell my company for 60 million either! My idea is huge, and I think it’s a home run and I want to go for it!” That’s obviously the right attitude, and it’s an attitude you will need, and it’s the attitude that your investors will want to see from you. Nonetheless, I don’t think it makes sense for most entrepreneurs to raise big A rounds, because you don’t want to price yourself out of interesting opportunities in the first year or two. By raising too much money, you force your hand on the kind of company that you have to build, whether you want to or not. Let’s look at two scenarios for a very promising startup with technology that may be of strategic interest to several profitable public companies (note to self - write a future post about the importance of not planning for or even thinking about exits like this):

Scenario 1: You raise 1 on 3 pre in an A round, so you’ve sold 25 percent of your company for a million bucks and you have a co-founder with whom you’ve evenly split equity, and you have a 15 percent options pool from which you quickly allocate 5 percent that fully accelerates on a change of control.

Scenario 2: You raise 10 on 40 pre in an A round, so you’ve sold 20 percent of your company for 10 million and you have a cofounder with whom you’ve evenly split equity and you have a 15 percent options pool from which you quickly allocate 1 percent that fully accelerates on change of control.

Six months into your post-A round, you are approached by Awesome Corp and they would like to buy your company for $20 million. Company that pursued Scenario 1 is in the following situation: founders each own 35% of the company. Founders each make $7 million dollars, investor takes out $5 million for a speedy 4x, and the options holders pull out the remaining million dollars. Ignoring taxes for the moment (much like ignoring friction in freshman physics, this is impossible and problematic, but humor me), this is a nice outcome for everybody. Your investors, it might surprise you, won’t be particularly thrilled, because it’s important to keep in mind that they are not in this business for IRR, they are in it for multiples, and a 4x on a fantastic new company with only $1 million invested is not that exciting. Still, at a 4x after six months, they’re probably not going to block the deal. It’s nice to make 400% returns in a short period of time. Now let’s look at the same offer if the company pursued Scenario 2. Ruh-roh. Do you think our founders are going to be cashing in any Awesome shares anytime soon? No, they are not.

But wait, don’t the founders actually own MORE of the company? Won’t they actually make MORE money individually? Why yes, they do own more of the company, but that was just a little trick I played on you. It makes no difference, because the investors, who have put up $10 million dollars, stand to take out $4 million dollars, and investors have this thing where their LP’s get very mad at them if they invest 10 and get 4 back after only 6 months. If our founders go look at their Articles of Incorporation and the term sheet they undoubtedly signed from the investors when they raised this round, they will see that the investors have blocking/veto rights, and the investors will veto this deal in a heartbeat. More likely, the company would never even get to this point, because the people at Awesome are going to look at the company cap table and realize that this deal doesn’t get done. The founders have set themselves on a course in which the only two possible outcomes are home run or failure.

I did my math above in 14 seconds and have no time for proofreading these days, so mea culpa if my percentages are off but you get the picture.

I would suggest that there are some very nice middle ground areas for the entrepreneur that hasn’t previously made a bundle of money, and many of these middle ground areas are still large enough to provide venture returns to institutional investors. By overcapitalizing your company, however, you can put yourself in situations where a potentially huge personal outcome is made impossible.

Fine. Let’s say you are only interested in huge home run or failure. The middle ground is for suckers, you say, and you are no sucker. You are an all or nothing hombre. Shouldn’t you now raise as much as you can in an A round? After all, you are in this to rock the world and make a huge difference and build the best damned company you can build.

No, I still don’t think you should raise as much as you can, for several reasons, but I’ll just highlight the most important. You will spend what you raise. If you raise $10 million, you will quickly ramp up to a burn rate of $800k a month, because the investors don’t want their money to sit in a bank account earning interest with 36 months of runway while you hire employees 2 and 3. The amount of money you raise sets you off on a course at a specific pace. Your board will want to know why you aren’t deploying capital. You will hire a marketing team because you can afford to hire a marketing team. You will hire a vp of sales before the product is ready because you can afford to hire a VP of sales. Companies that raise $10 million dollar A rounds don’t raise $5 million dollar B rounds, they raise $30 million dollar B rounds. If you have not accurately predicted how quickly you can grow the top line, you will quickly find that the cap table has gotten away from you, and you will have less flexibility to build the company the way you might like to if the market zigs when you thought it would zag. You want to give yourself the flexibility and room to react to market forces so that you can build the best company possible.

Final notes: It’s possible that by “raise as much as you can”, Marc is implying that the two first time cofounders with an idea that might sell for 20 million in six months will only be able to raise a million bucks. That’s fair enough and probably true. Still, even though I’m putting words in his mouth, I’d just caution that investors will always want to put more capital to work in a great company. Second, I hope that this post isn’t interpreted as “you should raise as little capital as possible” or “make sure you don’t invest too aggressively in your company”. Undercapitalizing your company is just as dangerous as overcapitalizing your company, with the added tragedy that undercapitalized companies sometimes miss out on their opportunities to be the gorilla in a huge market. You want to be capital efficient while making sure you are funding the growth of the business. If customer wins are accelerating and revenue is up 100% quarter to quarter, don’t try to get too cute about finessing growth on the cost side….ramp into growth and hire ahead of demand. More on that in another post.

Posted by Dick at 12:29 PM | Permalink | Comments (7)

So, you're out trying to raise your first round of financing, and you've gotten introductions to some VC's and you've had your first meetings and maybe even second meetings and now you're in "next steps" mode. Next Steps mode is where you ask everybody at the end of the meeting "what are the Next Steps?" and the answer you get is "we're interested. Keep us posted." The variation on the end of this kind of meeting is "When do want to close the round?" to which you respond something like "as soon as possible" or "we need to close the round by end of june" and the VC responds "ok, we're interested, keep us posted".

If you do not get an enthusiastic "what do we need to do to get involved" or "I think we'd like to do this, what's the timing" or "Can you come to our partner meeting next monday and present this to the rest of the team" then what you're generally hearing is "eh, i'm not convinced". Why don't they just tell you "eh, i'm not convinced"? Well, for a couple reasons: a) nobody wants to be the jackass that said no to the next Facebook or ebay, so it's better to leave the door open in case you turn around and really start to prove the model. That way they can call you in two months and say "hey! I asked you to keep us posted? Couldn't you tell how much we loved this? Why aren't you letting us invest!?" and b) nobody wants to tell the person that just came into their office with passion and determination that "i think this is stupid". Maybe it's just too early, maybe they just don't get it yet.

So, what do you do in these cases? Let's say you've met with six firms, gotten six "keep us posted" and you need to raise the money in the next month in order to keep going. There are a couple things you should do and a couple you shouldn't.

SHOULD: Go back to the potential investors and propose terms to a few of them as leads on the round. As I've said as many times as I can, you shouldn't get hung up on the valuation on an A round. Propose terms that are favorable to you but with a valuation the investors find attractive and aggressively pursue a commitment to lead from one. This will have the added benefit of exposing to you how much of their opinion was really "we're interested. keep us posted" and how much was "we mean 'no' but we don't want to say 'no'. HOWEVER, only do this in conjunction with the next SHOULD a paragraph down!

SHOULDNT: Try to bolster the company's look by adding impressive advisory board members. This isn't going to make a lick of difference to potential investors. Don't waste your time or equity.

SHOULD: Meet with a LOT more potential investors! You got six people who aren't impressed, but there are hundreds of folks out there looking to put money to work in early stage technology. Not everybody is going to get their A round done with their favorite investor.

SHOULDNT: Assume that if you pitched six second tier investors that the first tier investors will hate it too (or if you pitched six angels that hated it or pitched six first tier investors, etc.) When we started Spyonit, we didn't really know anybody and our first investor meetings were with four or five investors that most people have never heard of and a tier one firm. We were told everything from how stupid the idea was by the third tier/rate investors, to how it would be better if we were using Oracle as a dbms (not kidding) by the tier one investor, to the inevitable "we're interested, keep us posted". We then were introduced to and met with two of the best local VC's and they loved it. You simply cannot assume that the first six disinterested responses imply universal rejection.

SHOULD: Aggressively continue to try to mix and match a syndicate from the people you're meeting with. There are investors that like to work together and look for opportunities to work together, and you should attempt to discover those opportunities.

SHOULDNT: Sacrifice too much just to get a deal done. Don't put yourself in a position where a year down the road you are less excited about the business because of everything you had to give up in the first financing. Again, don't obsess about the valuation at the expense of everything else, there are lots of important terms, make sure you've got a company with room to run and room to grow that you're going to be passionate about if this funding gets done.

SHOULDNT: Assume you need to keep changing the pitch. If you're passionate about what you're doing and this is how you explain it, then that's all you can do. Just because the last person you met with said "this business would be better if it had a seafood component" does not mean you should go into your next meeting and add a slide with your Red Lobster Strategy. I can't tell you how many times people do this. Your job is to build your business, not build somebody else's business.....and it's particularly not 'build the business suggested by the guy who didn't like your business'. You should be open-minded to feedback but do not adjust your pitch higgledy-piggledy based on one off comments you get during meetings.

Posted by Dick at 10:37 AM | Permalink | Comments (2) | TrackBacks (0)

We'll see if I have the ability to write a short post on this blog. If there were ever an opportunity, here it is. Some VC's will ask entrepreneurs to sign a no-shop agreement as part of signing a term sheet. As usual, Brad Feld has thoroughly dissected the VC perspective on no-shops and I found this follow-up to his own initial post on the subject to be a very worthwhile read.

First, the very basics. Signing a VC term sheet with a no-shop clause basically means that you, the entrepreneur, will not continue to look for other investors to fund your company on favorable terms while you and the investor behind this term sheet hammer out your final agreement. Since the time between term sheet and closing the financing can be 30-60 days, you are obviously very committed to getting this deal done. Note that there is a wide range of VC behavior and you'll hear stories that run the gamut from assorted entrepreneurs. Most no-shops have a time limit associated with them like 30 days.

Here's my general thinking on no-shop agreements. I don't think you should sign no-shops for your A round, but I care less about them as the company progresses and you raise later rounds. I wouldn't sign one during the A round because during this time, you are spending an inordinate amount of time on financing. It's a full-time job for the CEO. Because you need money to really make progress, the no-shop on an A round really backs you into a corner. You *have* to get the deal done, because you need the cash to make progress, and thus, you are much more vulnerable to a potential investor trying to trade down on you as you progress...there can be any number of reasons/excuses for trying to retrade the deal, but all of them are bad for the entrepreneur who's signed a no-shop on an A round deal. So, all things being equal, I think signing a no-shop agreement on an A round is a bum deal for the entrepreneur.

In later round deals, eh, I don't care so much about this term for a couple reasons. First, I like to raise money when we don't need it (yes, I realize i wrote "I....we....". So shoot me). By getting out and doing a round when you don't need the money at all but know that you will 6-8 months down the road, you can be patient and aggressive and try to build the syndicate you want (yes, I realize I've now switched to the second person...enjoy the roller-coaster that is my lousy writing education). Where were we....Secondly, since you have money in the bank and you're growing the business, in theory, things should be getting better and better on a month to month basis. If the investor tries to re-trade the deal on you while you're under no-shop, you are in a lot better position in this later round situation than you are in an A round. Walk away from the deal if they try to retrade it and once the no-shop expires, start working with others.

The challenge with this advice is that if you're in a position of strength in a B or C round, it's probably easier to get the no-shop removed in the first place anyway, but nonetheless, I generally think it's something to avoid in an A round where you don't have a good feel for the investor's track record on these things, and something to be less concerned about in a later round as long as you've got money in the bank, you're growing well, and you've given yourself loads of time to get a financing done well ahead of the need.

Full disclosure - I have never signed a financing term sheet with a no-shop, so I couldn't tell you much about how hard these are to negotiate out. Other full-disclosure, every time I write "I" in this blog, I generally mean "me and the other cofounders and members of the executive team", but "I" feels so much more rewarding, you know?

Not such a short post after all.

Posted by Dick at 01:59 PM | Permalink | Comments (1)

I've gotten a few questions about convertible debt as an alternative to an equity seed round. I've never done a convertible debt deal, but since I keep getting questions about this, I did some digging around, and this wouldn't be the first time I've decided not to confuse experience or knowledge with expertise, so here goes.

There are a couple things to like about convertible debt and a couple of things not to like. Let's assume we're talking purely about convertible debt as a way to get ramped up in advance of doing a first bigger venture round.

Thing to like about convertible debt #1: You can get a deal done quickly. Your service really took off and you need to spend 100k on infastructure right now, you found a great vp engineering you have to hire right now, you need to buy 10 tickets to the Web 2.0 conference right now. Whatever, convertible debt will be generally be a faster way of seeding the company than raising an equity round.

Thing to like about convertible debt #2: If you do the convertible debt with a venture investor, you've now got somebody involved who's motivated to help you do your venture round, and you aren't flying so blind if this is your first time into the breach.

Both of these things to like are more than offset by a couple things to hate, in my mind.

Things to hate about convertible debt #1: Unaligned interests between the investors and entrepreneurs. This would be a good topic for a full post because there are lots of situations you can get into in which the investors interests and the entrepreneur interests are unaligned and they're probably all bad. In this case, successful serial entrepreneur turned successful serial investor Josh Kopelman has done a great job of elaborating on how interests can be unaligned with convertible notes as a seed funding approach. Also see the post Josh refers to by Brad Feld, who has written about pre-A round financings a couple of times himself.

Because the note will generally convert at a 20%-40% discount to the price of the qualified financing, the bottom line here is that you don't want an investor who's thinking "hey, if we can keep this A round down to a couple million valuation, then my notes convert at this nice low price and meanwhile the company's made all this progress....". You want somebody alongside you that's financially delighted to see you get a great price on the follow-on venture round. I can imagine that angels and other investors that prefer convertible notes will take umbrage to the suggestion that their motives are at loggerheads to the entrepreneur's here, but I don't like any situation in which you even see the suggestion of unaligned interests because it can potentially motivate wacky behavior. This is a reason to actually be wary of capped participating preferred and preference multiples as well, but that's another story.

Things to hate about Convertible Debt #2: The note holder doesn't want to convert on the venture round. Ruh Roh, George. You can set up the terms so that the note holder can be bought out or converted, but how much luck do you think you're going to have attracting a top firm to your venture round with convertible that won't come along? Why aren't they playing? What do they know that nobody else knows?

Things to note about any funding process #1: While a convertible note deal may get done a lot faster than a seed equity round, these processes all take time. We once did a B round financing with multiple investors in which structure, board makeup, etc. would change significantly from the A round financing, and this whole thing took about two months. We then later on did a B1 financing with one new participant in which literally nothing changed at all and the investor was as helpful as possible and it couldn't have been simpler and this process took two months. Why? Because no lawyer has ever used the "accept all changes" button in MS Word, that's why. And because documents need to be updated and t's crossed and i's dotted and all this is a giant pain in the ass and it always takes two months.

Despite this, you could argue there are a couple cases in which you the entrepreneur might want to play Convertible Debt Jeopardy. There are a variety of reasons anybody might take issue with this, but let's spell it out, since it's certainly a possibility for some kinds of companies. Let's say your startup is doing very well, and you need to grow. You've also been approached by some companies about a potential acquisition, and you'd like to entertain those, but you need cash to grow now. Convertible here could make sense because if you go ahead with the acquisition, you pay off the note and the capital turns out to have been very cheap indeed, and if you don't go ahead with the acquisition, voila, you've got somebody who can now help you go put a real venture round together and you were able to ramp into growth through the acquisition discussions. Note, however, that lots of seed round convertible debt investors might demand equity-like protections from this and negotiate for language that says if the venture round is pre-empted before they convert, they get a return of X. As always, everything's negotiable, even if the people across the table from you say "that's standard".

This post should not be taken to mean I don't like debt. There are lots of disagreements among entrepreneurs and investors about debt at various stages of the company and for various reasons. As always, we'll get to that in another post.

UPDATE: post updated to correct horrible spelling errors, a misplaced percent sign and a missing zero - generally shoddy craftsmanship.

Posted by Dick at 11:25 AM | Permalink | Comments (2)

The Wizard was out of town on vacation and what the Wizard learned on vacation is that the family makes no distinction between the evils of working or blogging on vacation. I'm back with a series of posts I wrote on the plane(s) based on assorted emails I've received.

First up, another important term in a venture financing term sheet, the liquidation preference. This section of a venture term sheet essentially defines how much money the people financing this round will have the right to pull out of the company on an exit before anybody else gets anything. Once again, Brad Feld has written an extensive and thorough post on liquidation preference, so I won't retrack all that ground here. Rather, I'll dive right into some of the key thoughts and distinctions and assume that you'll do the work of reading Brad's post first, or after this, or sometime.

I like FAQ's, and I got a lot of Liquidation Preference questions, so let's do this as a FAQ.

What is the liquidation preference?
Already with the questions that are answered in Brad's post? The liquidation preference simply (or complexfully) defines the money that will be returned to a particular series of the company's stock before the holders of any other series of stock. The Series A term sheet, for example, (always a good example because it's the easiest!) will define how the series A preferred shareholders will/can be paid before the holders of the common stock.

What the hell does the liquidation preference section really mean?
Here's what's going on. What your investors are doing here is making sure they get paid out on a subpar exit. Let's say you raise series A 5 million at 5 pre for a 10 post and then sell the company for 8 a year later and through the magic of simple examples, you never vested any options so the series A owns 50% of the company in preferred stock and the common owns 50% of the company in common. On the 8 exit, your investors have to be able to turn around and look their investors in the eye and NOT say "we lost a million bucks but the founder made 4 million" because that would "suck" and nobody would invest in their fund again. The liquidation preference defines the order and quantity in which an exit is paid out. The investors with a "liquidation preference" get paid first AS DEFINIED IN THIS SECTION, and then others are paid out.

Liquidation is bad. That means something happened that i didn't want to happen and we went bankrupt, so if I am a confident entrepreneur, I don't need to pay attention to this section, right?
Well, that was more of a rhetorical question, but no, that's not correct. This section defines how the moneys are going to get doled out on almost any kind of non-ipo exit, good or bad. Pay careful attention.

What's the difference between liquidation preference, participating preferred, capped participation, and a preference multiple?
I was afraid you would ask that. Let's see if I can really boil this down with examples. Here's sample language for a liquidation preference section of a term sheet that's about as vanilla and entrepreneur friendly as you could want. Maybe you'd like to start with the question "what does a vanilla liquidation preference section look like?"

Sure, I'll start with that. Uh, what's some sample language?
Great. Here's a very pro-entrepreneur liquidation preference language on a Series A term sheet.

In the event of any liquidation or winding up of the Company, the holders of the Series A Preferred shall be entitled to receive, in preference to the holders of the Common Stock, a per share amount equal to 1x the original purchase price plus any declared but unpaid dividends (the “Liquidation Preference”).
After the payment of the Liquidation Preference to the holders of the Series A Preferred, the remaining assets shall be distributed ratably to the holders of the Common Stock.
Upon any liquidation or deemed liquidation or Fundamental Change (as defined in the articles of incorporation, as mutually agreed in the negotiation of the definitive documentation), holder of the Series A Preferred shall be entitled to receive the greater of (i) the amount they would have received pursuant to the prior sentence, or (ii) the amount they would have received in the event of conversion of the Series A Preferred to Common Stock [with some blah blah blah exceptions].

So, what's a preference multiple?
Well, you see that 1x in the pro-entrepreneur language above? That might say 2x or 3x and that would mean your Series A investor have a 2x or 3x preference multiple on an exit. Let's say you raise 2 on 3 pre for a 5 post-money, but the liquidation preference is a 3x multiple. Although the investors own 40% and the common 60% (again assuming no vested options....options are like friction in physics examples....the math is so much easier without them), on a 10 million exit, do you think the Series A investors are going to want to convert to common and share pro-rata or do you think they'll just take their 3x preference multple thanks. The math is easy - they take their multiple and get 6 million instead of 4.

What's the concept behind a preference multiple?
Your investors put two million into your company on month 1, and you have so far put in no million but have come up with something that can attract 2 million at 3 pre. Good for you. A month goes by and somebody offers you 4 million for the company. You've only been working 2 months. No preference multiple? you get 2.4 million and your investor loses 1.6. But wait! you say, couldn't the investor just block the sale? Sure, the investor will have a blocking right. Ask most investors how they feel about blocking a deal when the entrepreneur or management team all say "time to sell!".

Can I negotiate a preference multiple out?
Go for it. As I've said before, too many entrepreneurs focus on valuation at the expense of everything else, and I would strongly encourage that you pay careful attention and energy on the liquidation preference and run through multiple scenarios to see what different outcomes entail.

Are you going to talk about particpating preferred? Did you already talk about it but in such a ponderous manner that we slept through it?
Participation, or the Double Dip as Fred Wilson likes to call it. Let's say instead of the language in the second paragraph in my example above where we saw "After the payment of the Liquidation Preference to the holders of the Series A Preferred, the remaining assets shall be distributed ratably to the holders of the Common Stock.", in term sheets with participating preferred, you'll see:
"After the payment of the Liquidation Preference to the holders of the Series A Preferred, the remaining assets shall be distributed ratably to the holders of the Common Stock and the Series A Preferred on a common equivalent basis.

See what's going on here? In a term sheet with participating preferred, the Series A investor doesn't need to decide if they want their preference or to convert to common and participate pro-rata. They do both. Some smart folks realize that participating preferred (aka participation) is only really fair at smaller exit values where the clause is in there to protect the investor and if the company does very well, the investor shoudn't participate inequitably. That leads you to your next question, right?

Um, what were we talking about again? I was just watching Escape from Witch Mountain on TBS
Right. Enter capped participation. Essentially "participating preferred up to a point". Again, I lift language freely from Brad Feld's liquidation preference post and include his example here:

After the payment of the Liquidation Preference to the holders of the Series A Preferred, the remaining assets shall be distributed ratably to the holders of the Common Stock and the Series A Preferred on a common equivalent basis; provided that the holders of Series A Preferred will stop participating once they have received a total liquidation amount per share equal to [X] times the Original Purchase Price, plus any declared but unpaid dividends. Thereafter, the remaining assets shall be distributed ratably to the holders of the Common Stock.

This is a great overview, but what do i care about?
You should run multiple scenarios on your liquidation preference language that help you see who gets what in different exit scenarios. Rest assured on an A round that you are likely to see strong investor preferences (some multiple or participation) and you may or may not be able to negotiate them away, but you can certainly try different angles. Everybody should be comfortable with a cap on participation, for example. Remember that you should never take "we always do it this way" as a valid answer to any of your questions or negotiations. Everything is negotiable. The valuation is under pressure? Maybe you agree to that if the liquidation preference changes. Maybe you take a term sheet with a lower pre-money valuation but more favorable liquidation preference language.

Any gotchas?
Well, sure, there are always gotchas. For example, when the language states that the investors can choose to convert their series A preferred to common, you want to check the Conversion section of the term sheet and make sure that conversion looks something like:

The holders of the Preferred Stock shall have the right to convert the Preferred Stock into shares of Common Stock. The initial conversion rate shall be 1:1, subject to [blah blah blah]

As always, I've left out a bunch of stuff but the post is already five times longer than I'd originally intended.

Posted by Dick at 11:00 PM | Permalink | Comments (4)

When entrepreneurs are raising Venture Capital, it seems like attention and focus are weighted 80% to pre-money valuation and a couple percent each to all the other terms, and I think this is a mistake. I've talked previously about obsessing over pre-money valuation in an early round (seed, A, B) at the expense of other terms, and I'll start talking about some of these other terms now in a series of posts. I'll try to interlace these posts with operations and company structure posts to keep things interesting for everybody.

Today's VC term sheet topic is Dividends. FeedBurner investor Brad Feld wrote about this topic extensively in one of a series of posts about Term Sheets from the VC perspective. I'm going to copy Brad's typical Dividend section language here and discuss it briefly from the entrepreneur perspective.

"Dividends: The holders of the Series A Preferred shall be entitled to receive [non-]cumulative dividends in preference to any dividend on the Common Stock at the rate of [8%] of the Original Purchase Price per annum[, when and as declared by the Board of Directors]. The holders of Series A Preferred also shall be entitled to participate pro rata in any dividends paid on the Common Stock on an as-if-converted basis."

The first thing to point out is that you should pay careful attention to the areas in here that will vary from deal to deal. Brad has done a good job of highlighting these. There are three of them and I'll talk briefly about each. Before I do that, let's briefly consider the "founding fathers' intent" behind the dividend section. The explanation you will sometimes get from Venture Capital investors is that the dividend is just there in case the deal goes sideways (not a home run, not a complete bust), and it therefore provides for some return on investment at some point that juices the investment and drives some value back to the investors. As Brad note in his post, "...[they] don't provide venture returns, they're simply modest juice in a deal."

So, as an entrepreneur, you would like to minimize the impact of any dividends you have to pay out. To simplify it in the extreme: Automatic cumulative dividends bad, non-cumulative non-automatic dividends good. If you're accruing an automatic cumulative 8% dividend on the investment dollars, you won't like what those kinds of numbers start to look like in year 5 and year 6. More importantly, cumulative dividends are an accounting nightmare and you will spend more time than you care to even know working with your finance team and auditors on how you should account for cumulative dividends and their effects.

Fortunately, Brad's typical language above makes our job easy, and we can quickly highlight what you want to negotiate in your term sheet. You want three things: a) you want non-cumulative, not cumulative, Dividends; b) you want the lowest possible dividend percent, let's say 6%; c) you really want "when and as declared by the Board" in this section because the board will include operating executives of the company, perhaps a founder, and different investors, and these will rarely, if ever, be declared.

Having said all this, an obvious question that arises is "if non-cumulative when declared" is so benign, why not negotiate the section out altogether? Obviously you can try to do whatever you want, but one thing any private equity investors are going to look to do in any deal is look for some opportunities to manage the downside risk. This is one of those sections, and just get this sucker to the point at which it causes you no pain. Non-cumulative when and as declared by the board is reasonable and causes you no pain.

I would suggest you read all of Brad's Term Sheet posts if you're out raising money. Brad writes in a very common sense way that generally reflects both sides of the discussion about Term Sheets.

Posted by Dick at 11:34 AM | Permalink | Comments (2) | TrackBacks (0)

A commenter on a previous funding post noted that I discussed having personally done different sorts of financings including Friends and Family but then didn’t elaborate on this point. I’ll remedy that now in a short post on the matter.

There are two things I hate about friends and family financings and one thing I really like about friends and family funding.

First, the good news. I generally think these are great ways to finance companies that might not need much more capital. If you can get off the ground with a small financing that friends and family can perform and that ultimately takes the business to cash flow positive, then this is a great way to go. You don’t have investors that necessarily need to get liquidity at some point, you probably have much more favorable terms, etc. You can grow the business at your pace and everybody’s happy.

However, as the commenter on my previous post noted, the more emotional connection that one has to friends and family investors can be a real problem and may lead to one or more of the following: a) not throwing in the towel when you really really ought to throw in the towel, b) not being honest with your friends/family/yourself about the state of the business if things aren’t going well (and you’re going to want SOMEBODY to turn to!). Finally, there's the general emotional distress if you are in a situation where you aren’t as far along as you thought you’d be at this point and your friends and family "need their principal back". Uh-oh, that’s not going to be a good time for anybody.

The second reason to dislike friends and family funding is when you follow it up with a more formal venture financing. Your venture investors are going to want preferred stock with all sorts of special rights and privileges and now you are in the uncomfortable position of telling your Uncle why John Doerr’s dollar is worth more than his dollar. Although that wouldn’t be too uncomfortable a position as you could follow that by describing some of John’s other investments, but I digress, and hopefully, you see my point.

One last thing – the comment on my other post asked that I blog how it worked out when I raised friends and family money. Fortunately, it worked out fine. It was my first entrepreneurial endeavor, it was family not friends money, and when things were rough sledding after a few months, there was a healthy dose of motivation due to “owing” the family money that probably got me through some early jitters and second thoughts.

Posted by Dick at 07:03 PM | Permalink | Comments (4)

As I mentioned in the last post, there are about 42 lengthy articles you could write about how to fund your company, and as veteran Chicago entrepreneur Al Warms points out in a comment on my previous post, I skipped right over Funding101 - What are your goals?

I had a different context in mind for my last post, but Al's great comment merits elaboration. As Al writes, if you only think you're ever going to need a little capital and your goal is to build a small business with less than ten employees that will throw off a million bucks a year in cash every year after year 3 until hell freezes over, then you shouldn't raise a bunch of venture money. Again, as Al points out, early stage VCs are looking for a significant multiple on their invested capital, and they'd ideally like to see that return sometime in the next 5-6 years (although the multiple is probably more important than how long it takes to deliver it) so that they can deliver profits to their investors, raise another fund, fund more companies, and lather-rinse-repeat. Al notes that you should ask yourself "Do i think this could be a 100 million dollar business?" and "Am I prepared to go for it with only that potential outcome or better in mind?" when you're trying to decide how to fund your company. Of course, in the early days of a new idea, you may think the answer to both of these questions is a resounding "Yes!" and then find yourself thinking otherwise a year later. I'll add some additional points and more context to Al's questions.

First of all, if you raise venture capital, the rights of the preferred shareholders are almost certainly going to include a blocking right on sale of the company. Huh? Why would they want to block a sale of the company? Entrepreneurs frequently bristle at this, especially on a first round deal where the founder still owns 70% of the company, however, a simple example highlights why you are almost always going to see this term. You raise 2 million vc bucks at a 3 pre-money for a 5 post. The vc's own 40% of the company, you own 60% (let's ignore option pool for now). You spend a bunch of money on infrastructure and upfront legal stuff, and then Shmucky.com swoops in a month later and says "hey, i'll give you 3 million cash for your company and a 1 million dollar personal signing bonus". You think "hey, 2.8 million to me for a couple months work, hooray for me!" You see the problem. Your investors are going to have a very bad LP meeting if they get into these kinds of situations, so they are always going to make sure they have a blocking right on sale. The point being, you don't want to raise money if you've answered Al's two questions "Yes, but I'll still own a majority so I'll just do whatever I want".

Even more important is the context underlying Al's two questions. You're not really asking yourself if you think this is a 100mm business, because of course, you have no idea at this stage if it's really that big. The point, however, is that you need to ask yourself if you really think this is such a big opportunity that you're willing to take on significant risk in multiple forms in exchange for the significant capital to pursue the opportunity. Certainly, there are any number of very successful entrepreneurs who have chosen the path of smaller company with steady and growing cash flow with limited downside risk. Here in Chicago, we can look no further than Jason and David at 37Signals who have created a) a huge following with significant notoriety for themselves, b) a profitable company in a short period of time with few employees, c) limited downside risk - Jason does not have twenty million of preferred hanging over his head. He owns some significant percentage of 37Signals and he can sell the company, keep watching it throw off cash every year, add another employee every 36 months, or decide to stop working tomorrow and tell his customers he's refunding their money for the year and shutting down the operation. While the last option is highly unlikely, Jason is afforded the luxury of having it available to him since he hasn't raised a bunch of institutional capital. The company he's built suits his goals extremely well, and it wouldn't suit him to raise a bunch of money and try to grow the company to 50x its current size because Jason doesn't want to have 100 employees, he doesn't want to have board meetings where he talks about how the quarter is shaping up, and he doesn't want to shut out any future options for himself.

So we can call this Al's rule number 1 of starting and funding a company- what kind of risk am I comfortable taking on vis-a-vis my goals for myself and the business? Once you've answered this, then you can move on to my previous post.

It strikes me now that I think of it that there are lots of great examples of successful or success-in-process companies that haven't raised institutional capital, and I'll try to talk about more of those here, so that people get a better sense for the different kinds of options you have.

Posted by Dick at 09:03 AM | Permalink | Comments (5) | TrackBacks (0)

Another topic about which there's a lot to say. You've decided you need to raise money to grow your business, and you are trying to decide how you should fund it - Angels, Friends and Family, or Venture Capital. My cofounders and I have done all three, so I'll offer some quick highlights. This by no means covers the topic completely.

First of all, one quick way to think about this is the farther up the professional investor chain you move (from family to venture), the more you'll have to have the company setup in specific ways. For example, you may be able to setup your company as an LLC or S-Corp if you're not funding the company with venture money. The most obvious advantage of setting up an S-Corp as opposed to a C-corp is that the profits and loss pass-through to the shareholders on a pro-rata basis, and there's no double taxation like you get with a C-corp. Why does venture funding mandate that you create a C-Corporation? For the simple reason that VC terms will mandate that they get a separate class of stock (preferred) with rights that are different than those of the common stock, and you can only have one class of stock in an S-corporation. Note that if you haven't decided how to fund your company, you can always convert an S-Corp to a C-corp as part of a financing, but always remember, when you're talking about changing company structure, articles of incorporation, etc., somewhere an attorney is going to get paid a lot more than you think they should.

So, if you lose the tax benefits of an S-corp with venture funding, and VC's are going to insist on spending $30k to have the company's finances audited every year, why not just track down a bunch of rich folk who will buy a chunk of your common stock in a private placement? There are a couple major reasons to choose venture funding or sophisticated Angels that understand your industry if you're planning on building a big business. First of all, although all individual investors need to be accredited (legalese for "i declare that i'm a millionaire on some ledger somewhere"), and some people are more accredited than others. If the market tanks, you don't want to be responding to panicky emails wondering if you've talked to shmucky.com yet about buying the company. You want investors who will be patient through growth. VC's are always going to encourage you to keep growing when you're growing. They've got a portfolio of investments, they're managing risk across a portfolio, and they're not going to be antsy to jump off a speeding train. Secondly, as you're building the company, experienced VC's are going to have been through multiple examples of whatever strategic and tactical issues you're dealing with, and it's very helpful to have people who've fought these battles before sitting in board meetings discussing the issues. The guy who invented rollercoasters may be rich, but he might not be very helpful with your sales force automation issues. (I suppose it's sexist of me to assume it was a guy who invented rollercoasters. It may very well have been a woman, or rollercoaster may even be two words; I have not done my homework on these points).

What do I mean by "sophisticated Angels"? I'm referring to folks who have made multiple investments in your industry, understand the space well, and maybe even still have operating roles in the market.
Reid Hoffman is a great example in the consumer Internet space, and there are lots of others.

Particularly in a "bubbly" market like the one we seem to be in now for investing in technology startups, I think it's wise to look to more formal investors like VC funds and sophisticated angels for the reasons I mention above.

I wouldn't generally worry about how negatively an Angel/Individual investor will affect you in a future VC or other institutional financing. If your company is growing and strong and a winner, people will find a way to put capital to work. May cost you a chunk of money in legal and accounting fees to get everything refactored for professional investors down the road, but even the simplest financings cost too much in legal fees, so I don't think that's particularly insurmountable.

This post is only leaving out about 41 other points to consider, so we'll come back to those another time.

Posted by Dick at 03:03 PM | Permalink | Comments (1)

You could probably create a blog with nothing but "pitching your company" posts and keep it going strong for a good year or more, and this is probably the topic I get the most email/questions about from folks that are trying to figure out how to fund their company. There are a million things to say about this, but I'll try to start off by focusing on getting ready to pitch your company to potential investors and then the actual pitch when it's time to go out and raise that first round of capital. Whether you're looking to raise your first round from angels or a venture fund, there are some general ways of thinking about your pitch that are probably helpful.

Getting Ready
I've seen a lot of discussion about the relative value of business plans on some venture capital blogs. Do you need to create a business plan? Most investors will tell you that these are a great exercise because they help you collect and organize your thoughts about the business with some rigor, although investors will also generally tell you that they only read the executive summary of a business plan. I have personally never written a business plan in my life and don't imagine I ever will. I don't have any interest in writing a business plan because in the consumer Internet software market, 9 times out of 10 you don't end up building the company you thought you were going to build when you first started. The market zigs when you thought it would zag and you end up adjusting and improvising to the market. This does not mean that when you pitch your company you should say "we're going to do X, Y, Z, and then we're not sure what the hell is going to happen but we're hopeful it will be something good!"

I do three things when preparing to go out and raise money. First, you want to line up a bunch of people to talk to in a very short time. It is critical that you generate demand for what you are doing. One question you will hear at the end of most VC meetings is "what's your timing?" and you want to use this opportunity to reply that you're meeting with a bunch of folks this week and you hope to put something together quickly and get back to work on the product. You are trying to sell yourself here, and the best way to position yourself is to generate as much demand as quickly as possible. So, you want to get the list of people you need to meet put together and get meetings set up that allow you to do three or four of these meetings a day. Second, get a demo and a small pitch deck together, anything from 8-12 slides is fine, and anything more than that is probably too much. If you find yourself reading this and thinking "There's no way I can pitch everything about my product in only 8 slides", I assure you that you are wrong. Nobody wants to sit in a room and read data-packed powerpoint slides with pull quotes from Gartner Analysts that describe your market as being a 9 bazillion dollar industry in 2012. Get a short pitch deck together that tells a story. Here's who we are, here's an opportunity/painpoint we discovered, here's what we're doing about it, here's how we believe we will be able to leverage this in amazing ways, and here's how much money we need to accomplish these things. End of story. You might also include "here are the other people who are working in this space and they are focused on these kinds of things", etc.. Third, you should put together some very high level financials that outline how the business probably works over the next couple years, paying particular attention to the operating expenses in year 1. Few people are going to believe your revenue forecast for year 2, and even fewer are going to believe your revenue forecast for year 3, but it's important to highlight that you understand how the business grows, where the cost inflection points are, where the revenue/margin leverage points are, etc. Bottom line - don't go excel crazy on the financials with all sorts of goofy details but paint a simple and clear picture of what the general financials look like as you ramp up over the next year. When will you need more money, what might that financing look like, etc.

Pitching the Company
This is the fun part. If you haven't ever done this before, you're probably nervous going into your first meeting, but you're about to market test your company, and that's a lot of fun. Some of my best friends in the industry are the VC's I've pitched and some of those people have even invested in the companies. I think there are four good tips for pitch meetings.

1. Be prepared to do your pitch with either a quiet unengaged audience of 1 or an energetic, questioning and engaged audience of many. In some meetings you might get through your entire pitch and a complete demo with no questions, and in other meetings you might not get any farther than an opening demo. Whatever. Don't have preconceived notions about how these things should go. They're all over the map.
   
2. If you are pitching VC's or Angels who see a lot of deals, take advantage of this time you have to listen to their feedback. You are getting feedback not just on your product or service but how it's perceived vis-a-vis the forty other things in the market that you won't personally know anything about for month to come as these other companies get funded, launch, etc. Don't focus solely on getting through your pitch - ask your own questions, ask for clarification if you don't understand an answer, and listen. As stupid as this sounds, it can actually be hard to take the time to do this because if you're really passionate about what you're doing, and you should be, then you're going to be focused on communicating your vision and articulating how you're going to attack the market. You can learn a ton from meeting to meeting by asking questions and listening and that will help improve your pitch as you go.
   
3. Try to get to know the people you're pitching. Hopefully, you are going to have your choice of a number of potential investors if you're lucky, and you want to make sure you are working with people you like. As I say, I've gotten to be very good friends with several folks we've pitched, some of who've become investors and some who haven't.
   
4. Have fun. You are going to be pitching your company for years to come if you're successful, and to bigger and bigger groups of people, so I recommend trying to have a good time with this process. It doesn't end once you've raised money.
   

I'll say one more thing about pitching the company. In a couple of pitches people have asked me to look at lately, the entrepreneurs describe their likely exits. Ignoring for the moment that you have absolutely no idea what your "exit" is going to be or when it will be, I'm not sure that any investor would ever react positively to this as part of a pitch. At best, it comes off as naive, and at worst, you expose yourself as having some too low expectation. If a potential investor asks "how does all this play out?" well then that's another question.

Man, I need to work on some shorter posts. I'll try to mix in some quick bits with the treatises here. Still lots to say about ending the pitch meeting and follow-up.

Posted by Dick at 04:03 PM | Permalink | Comments (6) | TrackBacks (0)

I think I'll start off with some general thoughts on funding a startup and then after getting a few Introduction to Funding posts out of the way, then I can dive into more details later on term sheets from an entrepreneur's perspective. The first few posts here will be super basic, as I think there's a dearth of this kind of stuff out there in the wild.

There's been a lot of discussion the past couple years about the fact that Internet startups need less funding than they used to because hardware, software, and bandwidth costs have all come down. It's certainly true that you can successfully bootstrap a startup more easily now. 37 Signals and Bloglines are two good examples (one still private and one sold to Ask.com) of successful startups that got very far before or without raising money. There are plenty of other examples. FeedBurner investor Fred Wilson had some excellent thoughts on funding dynamics in the Web2.0 world.

The reality is that every company is different. YouTube was obviously going to be a capital intensive business with a huge bandwidth bill. Generally speaking, I would probably never spend more than 6-9 months working on a company without raising money, because I prefer to work on platforms that can be extensible to massive audiences, and if you want to build and develop extensible platforms, then at some point you're going to spend a lot of money on infrastructure. So, if you're just getting started, and you don't know much about funding or how much you're going to need or even who to talk to (angels?, VC's?, Friends and family??), what should you do? My strong suggestion is to start working on your idea without raising money and keep going until you've gotten your product or service to a state in which a) you have a good feel for whether you like its chances of success in the market (you might rephrase this to say "now that you're looking at something real, are you still as passionate or even more passionate about it?"), b) you have a very general feel for how much money you think you'll need in the next year. For the FeedBurner founders, this time period has been about 4-8 months in our last couple of startups.

There are a couple benefits with taking this initial bootstrap approach. First, once you have investors, you have some level of obligation to others than yourself and your employees. It gets significantly harder to just say "this isn't as exciting an idea as I thought it would be, I think I should focus on something else". Second, in most cases, particularly for a first time entrepreneur, it's going to be a lot easier to attract funding for a product or proof-of-concept that you can demonstrate to investors. The first two reasons for bootstrapping for a half a year or so are somewhat obvious, but there's a less obvious reason. In my opinion, you don't want to raise enough money to last you three years on your A round. The money that you raise costs you equity. Theoretically, you will increase the value of the company every week, month, year that you work on it. By raising 5 million dollars when you're only planning on burning 1.5mm the next 12 months, you are shortchanging your ability to raise the incremental 3.5 million at much more favorable terms ten months later. I mention all this because I've heard a few entrepreneurs talk about how much runway they've got, and I'm not sure that's necessarily a good thing. So, by waiting a few months before you raise money, you'll hopefully have a better feel for pace and potential burn rate and can raise an amount that comfortably gets you through the next phase of growth. The one caveat I'll mention here is that it's been my experience that even when you're capital efficient, you always spend money faster than you think you will in a startup, so make sure you raise enough to get you through the next phase of growth.

The other benefit to only raising as much as you need to get you through the next phase of growth is that companies (now speaking VERY generally!) tend to spend what they raise, unless you are particularly rigorous about being capital efficient. It's a lot easier to say "yes" to the monthly PR retainer from the high-falutin' pr firm with the great client list if you've got "extra" cash in the bank. It's a lot easier to say no if you're managing to a burn rate that's not cushioned with loads of extra cash.

The problem with advice like this is it invites comments like "but Google did one big 25mm dollar raise after their seed funding and look how well that worked". It's important to remember that you can't apply a one size fits all approach to thinking about these things. This is just a general framework for the way I like to think about getting started.

In the next post I'll talk about VC vs. angels vs. friends and family. Fortunately, I've done all three in different companies, so I there's a slight chance I will actually have some idea what I'm talking about. We'll see.

Posted by Dick at 11:45 AM | Permalink | Comments (4) | TrackBacks (0)