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VC Essential Tensions: Momentum vs. Contrarianism

It is my intention to begin a series of entries dealing with “essential tensions” in investing in general and VC in particular. This is the first of the series.

Venture capital as an industry deals with momentum investing. Paul Kedrosky has argued on his Infectious Greed blog that VC is a “bubble business,” and that venture returns, when they’re good, come from momentum-fueled exit events. This is an argument where the counterexamples are the exception that proves the rule: Google’s IPO (unimpeachably a deal that stands on its own merits rather than a momentum exit) stands out for having decisively ended the exit drought that had plagued the industry since 2001. Indeed, GOOG going out kicked off the recent positive-momentum exit cascade that gathered steam throughout 2006.

Likewise, on the “entry” side of new financings, momentum tends to rule the day (especially when exit momentum “spills over” into fundraising and new financing activity). See, for example, the cavalcade of YouTubettes that have been trotted out, freshly funded and hoping to hit warp 10 and slingshot off the perceived stellar performance of online video and user-generated content. (Indeed, it would take some backwards time-travel for most of these to capture any fraction of the value in that particular space.)

It is easy self-righteously to laugh at the absurdity of funding 30 YouTubes. But if we accept whole-heartedly the ad absurdum version of Kedrosky’s argument, we can’t blame VCs for believing in momentum. After all: if folks today are buying online video companies, then the savvy VC better have one to sell.

But investing is not a game played alone, and contrary to the bluff and bluster of some VCs, no deal is “binary.” Every deal is implicitly an auction, with a bid and an ask, and the formula for investment return is ancient and venerable: buy low, sell high. Momentum helps with the latter, but crushes our ability to do the former. Apart from the occasionally perverse incentives provided by large, fixed fund sizes, pricing going in is even more leveraged in ROI than pricing coming out. Getting into a good deal at an attractive price — and hence, the longer lever on ROI — depends on a virtue diametrically opposed to momentum, namely, contrarianism.

The contrarian looks for undervalued purchasing opportunities by ignoring or subverting the prevailing wisdom of the day. He makes it his job to call the tops or bottoms of markets, and sometimes is the one declaiming the emperor’s nudity. An occupational hazard of this is that sometimes, the market has a ways to go yet, and occasionally the emperor still has flesh-colored tights on — and early is the same as wrong when timing markets.

Certainly, if there is a mythical hero of venture capitalism, it is the steel-nerved visionary contrarian who makes what looks like a long-shot bet, boldly doubling down when others are fearful, and propelling forward great companies and great technologies that nobody else dared touch (and hence, that he invested in on the cheap). Where else do we get the nerve lionizing our asset class as “venture?”

So, we are faced with a contradiction between the mythology of our industry and the harsh reality. You don’t get to be both the visionary contrarian and still have the online video portfolio company. Why do so many venture firms seem to choose momentum in this tradeoff?

I have two theories. One is that, although entry price has more theoretical leverage over ROI than does exit value, exits are so much more visible that they dominate the consciousness of most VCs. That is, given the implicit opportunity to make a 8x ROI on, say, a $60 M exit, or to make a 2.5x on a $500 M exit, and assuming that the probabilities and amounts are adjusted to keep other comp and performance measures ceteris paribus, I bet that VC decision processes are strongly skewed to the big dollar, highly visible exit. Half-billion IPOs are much better bragging fodder at the VC confabs than mid-market M&As, even though the latter may well pay off better. This would be a great master’s or Ph.D. thesis if one could substantiate and measure the value of this skew.

The second theory is a general theory for understanding why contrarianism, itself, is “meta-contrarian” (that is, why contrarianism is selected against as an investing style). I call this the “rich friends theory.” I use it to explain why, despite all rationality, U.S. investors tend to overweight U.S. equities in their portfolios. In a nutshell the theory is this: it sucks far worse to miss out on an investment opportunity that all your friends have scored on, than it does to miss out on an equally profitable opportunity that everyone else missed, too. Put another way, it’s awesome to get richer than your friends, but it’s way worse to get much poorer than them. Thinking of this “peer-relative risk aversion” helps to understand a lot of bubble / momentum dynamics. This, too, would be fascinating to measure, although I can reasonably set a lower bound here of 0.7% skew toward the crowd, which is the “rich friends tax” you pay in incremental house edge at craps by playing the pass line (the “do’s,” where most players play, has a house edge of 1.41%) vs. the don’t pass line (the”don’ts,” almost diametrically opposed to the do’s, where winning earns you enmity and losing earns you jeers from your fellow punters, has a house edge of 1.40%).

There’s also a case to be made that emerging managers hew more closely to the herd because it could be an existential crisis to a firm for its first fund to be a “fourth quartile” performer. Much better for a new firm to post median returns and live to raise more funds, than for it to risk lagging returns on a series of contrarian bets (better, that is, for the firm, if not for its investors, who may in fact be better served by the longer-shot odds). This is, of course part of the “tyranny of IRR,” about which I have another blog entry under preparation.

I wish I could say that understanding, or even measuring, these effects gives you some kind of instant edge in investing. But, alas, this is a perfect example of the occasional frustrating impotence of mere understanding. (I do have some ideas for exploiting this particular case, but those obviously aren’t public.)

VCs Are Not Your Channel (But They Might Be Your Friends)

Occasionally I get calls from folks who get the bright idea that, since VCs have a bunch of portfolio companies under influence, they can leverage selling their stuff by talking to me instead of pounding the pavement to the whole portfolio.

If you’re thinking of doing this, remember that we (VCs) are not your personal sales channel into our portfolios! Consider:

  • VCs generally take a board seat at most; we influence our portfolios, not control them, and we do so at a fairly high and abstract level.
  • Most VCs abandoned the “incubator” model after the ’90s bubble; we prefer that our portfolio companies seek the best service providers for their particular needs rather than establish some sort of Gleichschaltung.
  • We ain’t in it for charity! We’re trying not only to build and sell our portfolio companies, but to seek out new deals, with new capitalizations, and to boldly go where no man has gone before! (er, sorry.) Star Trek aside, this takes up our time, so even if your shiny new product (or dreary old service) is really groovy for a portfolio company, unless it gets them to an exit or gets us a new deal, it’s probably best dealt via a different contact.

Now, all that said, there are some cases where using VCs for leverage into their portfolios does make some sense.

  • You have some particular specialized characteristics that suit one VC’s portfolio well. This could be a mix of geography, stage, domain expertise, etc., like, say, a life sciences IP law firm that caters to early stage firms in Botswana might find affinity with a VC with that same focus.
  • Your sale is at the board level. C-level recruiters come to mind (although this is emphatically not guidance for recruiters to start badgering VC board members).
  • You have some referenceability within the world of VC-funded startups. These people talk to each other, go to work for each other, and start companies over and over with each other. Your sales into big companies (even tech) or lifestyle businesses (even small “startups”) are not representative of what the experience with a VC-funded firm will be, and won’t necessarily reference well among such firms.
  • Your offering will almost certainly speed a company to exit at an excellent valuation (hint: you can’t, or else you’d be a champion VC yourself).

What should you do if you decide to make the pitch?

  • Do your homework — it’s fairly trivial in most cases to discover a VC’s portfolio and the specific investors (partner) on each board.
  • Use your homework — figure out which portfolio companies you have a great deal for, and make your pitch to the specific investor affiliated with that company.
  • Reference successes and, ideally, get referred in. Find other venture-backed companies that you did an amazing job for, and, if possible, get the CEO or VC board member from that company to recommend you. This would be the holy grail introduction.

I personally try to be helpful to decent and courteous sales / biz dev folks, but I think that reading and acting on the above is a bare minimum level of courtesy for sales / biz dev people talking to VCs.

Hint: Nobody Has Any Idea How This Thing Works

In Venture Capital, we have lots of rules of thumb for assessing entrepreneurs. Some such rules are:

  • Invest in guys who are already rich, because they have fewer distortions in their motivations.
  • Invest in guys who aren’t already rich, because they’re hungry.
  • Invest in guys who have put their own wealth at risk, because they have “skin in the game.”
  • Invest in guys who have raised outside capital from credible investors.
  • You gotta outsource the tech stuff — it’s too expensive.
  • You never outsource the tech stuff — it’s too important.
  • Entrepreneurs should not come from a big company (because they have the wrong culture).
  • Entrepreneurs should come from a big company under a big-ego boss (because they want to make their own name out from the shadow of the big cheese).
  • Only young guys get this new (social networking, Web 2.0, whatever) stuff.
  • Only seasoned old guys will make any money.

When you’ve got guidelines like this, many of which are quoted with nary a trace of irony by the practitioners of our art, it’s fairly clear that you actually don’t have any useful guidelines.

Except one: invest in guys who’ve done it before.

The only person you know has a shot at creating a company with an exit value over $100 M (which is about the minimum exit value that most VCs would admit to wanting in any case, so I’ll use this as the threshold for my definition of a “star entrepreneur”) is the guy who’s already done it. Everybody else hasn’t yet proved it.

However, we have a major signal-to-noise problem here. When you look at an entrepreneur, even if he’s a star, you don’t know to which causes and in what proportions to attribute that stardom. Certainly, the quality E of star entrepreneurship could be the cause. But it could also be quality L (for luck). With only one exit, you just don’t know. But with no exits, you know even less.

If you were a statistician, you might try doing something with a Chernoff bound or a Z-test to figure this out. But a few things confound this approach. The main problem is that your number of trials is usually one. You can’t just keep tossing the coin to see if it comes up heads 51% of the time; you have to somehow guess the bias after only one flip (no pun intended!).

Another big source of error is that successful exit events are fairly rare. Most venture funded companies don’t have successful exits. (The old chestnut about VC is that a fund makes ten investments; five fail, 3 or 4 return 1x capital, and 1 or 2 make a 10x return. That’s hardly accurate, but it’s a good enough schematic for understanding the rarity of successful exits.) So if the probability of any given entrepreneur having a successful exit is 10%, then even a “rock star” who is five times better than the average is still only even money to exit big.

So, we have lots of both Type I and Type II errors. Finally, successive startups are not independent trials. That is, unlike rolling the dice, each startup you do is affected by the previous ones (both the experience of doing them and the ultimate outcome).

Even when an entrepreneur has been successful in the past, we don’t know if he’s likely to be successful again (though we can say, on average, he’s more likely to succeed than a newbie). But often, we fail to reject the guys who “hit the lottery” with their previous success. And even more often (almost by definition), we end up rejecting highly promising entrepreneurs who haven’t yet had a home run.

Yet, somehow, VCs continue to invest, and the returns (compressed due in large part to excess capital seeking a home in alternative assets / private equity) have continued to be good (if less princely than in the early years of VC). So VCs aren’t just monkeys throwing darts; we do have some discrimination ability.

Another chestnut in the VC industry is that “it takes $X million (e.g. $30 million) to make a general partner.” That is, to get a venture investor to the level of a seasoned senior investor, he needs to have led $X million in deals. This amount of deal flow (or, as it’s sometimes told, losses) is required to build up the black box of intuitions, gut feelings, sixth sense, etc. that a good general partner should have.

To me, this is a bunch of horse hooey. Yes, any good seasoned professional in any field will have some pre-rational judgment abilities that appear to be a “black box” — but these should only come into play at the margin. The core of any professional discipline must be reducible to a teachable, coherent syllabus. Take, for example, Malcom Gladwell’s example in Blink of the use of the Goldman algorithm for diagnosing acute myocardial infarction (heart attack). Essentially, the algorithm kicks the ass of expensive cardiologists and other “professionals” at doing one narrow thing, which is telling whether a heart attack is happening.

Now, the human body is a system, replicated and observed over billions of instances, with trillions of dollars cumulatively spent on measuring and exploring it. It provides feedback continuously on a second-by-second basis. And a heart attack is a fairly catastrophic and disruptive event — the death of part of the most important muscle. So the fact that a relatively simple algorithm can discriminate that event with great specificity is perhaps unremarkable.

But what is remarkable is that it took until the mid-eighties to promulgate the Goldman algorithm, and even today it’s not the gold standard. (Hey, at least medicine has the Goldman algorithm: in VC, nobody yet has validated such an approach.)

Doctors and VCs both have acute cases of what I call “special snowflake syndrome:” both groups tend to believe that they have special, irreducible talents and skills at doing whatever they do, and that they could never be replaced by a dumb machine. It is no coincidence that special snowflake syndrome tends to strike those in high-income jobs; folks who’ve seen automation or offshoring put downward pressure on their wages tend not to subscribe to this conceit. We also see special snowflake syndrome in industries where there are relatively high barriers to entry, such as regulatory (medicine) or timing / liquidity (10 year partnership agreements in VC).

In both cases, special snowflake syndrome will inevitably lead to heartbreak as people without the illusion of snowflakeness find and implement things like the Goldman algorithm (and the coming, immodestly named Lucas algorithm for VC). Unfortunately for the doctors, they won’t be capturing the economic surplus that results — it will be the middlemen in the hospitals and insurance behemoths that soak up the savings. (Doctors: save yourselves now, by demanding economic ownership of your patients’ well-being, the only humane and just way to allocate costs and risks in your profession!)

Fortunately for VCs, the implementation within a partnership of the Lucas algorithm will enhance that firm’s ability to identify and make successful investments with greater certainty and less manpower. And since VCs, through the carried interest portion, are compensated on financial performance, this will ultimately benefit the adopters. Yes, there will be some Schumpeterian woe for the old-school hangers-on as the snowflakes of their egos are melted in the sunshine of the new day that will be ushered in. And yes, a certain few of the old-school VCs — the ones with really great black boxes and/or Rolodexes — will continue to enjoy their maverick road gambler reputations. But by and by, rationality is coming to our market. Our black boxes will help us make decisions at the margin, but our algorithms will drive our core activities.

Does anybody want to work
on the algorithm with me? (I’m willing to hyphenate the name of the algorithm.) Drop me a line or give me a call at Voyager, +1 206-438-1822. (There will, of course, be several variations for different industries, geographies, stages, and firm preferences — so much so that each firm will likely need its own implementation — which is why I’m not too concerned about giving away competitive advantage by discussing with others in the industry.)

Guy Kawasaki Hates Me

In a post entitled The Venture Capital Aptitude Test, quasi-famous blogger and sorta-VC Guy Kawasaki rags on junior venture investors in general and on young VC associates in particular. He prescribes “contempt” for “any young person who opt[s] for venture capital” and implies that such people are “full-of-shi[t]” (saying “shiitake” when you mean “shit” is just barely cute enough to countenance the first time, Guy, but let’s call a deuce a deuce).

In other words, Guy Kawasaki hates me.

Now, I am by no means the archetypal target of Guy’s scorn — his sharpest comments are reserved for MBA and I-banking types without operating experience, and he has a soft spot for those of us with engineering and sales backgrounds. I have, in fact, nothing but operating experience (two software startups, one profitable, one defunct) in my career to date, but being in my late twenties and working for Voyager Capital is inexcusable to Guy.

Guy sets up a straw-man argument, viz:

1. Working in VC is the best way for a young person to learn entrepreneurship.

2. Young seekers of VC positions are motivated by gigantic ($500k) salaries and massive carried interest portions.

3. Young VC associates are great candidates for shepherding along startups through their challenges.

Unsurprisingly, Guy knocks down that straw man, says “shiitake” a couple times, and then congratulates himself. Hurrah! He does so with the help of an interactive, Cosmo-style quiz that asks fairly shallow questions about who one is (“background”), what one has done (“first-hand experiences”), and what knowledge one has (“necessary knowledge”). Cognitive dissonance must set in for him around here, since his California-Bay-Area-influenced emphasis on “direct experience” was offset by an ancien regime-style weighting toward character and background (it’s Baba Ram Dass vs. the Greek chorus). Finally, Guy racks up the comments — mostly strokes for Guy with a bunch of self-reported high (or low!) scores and self-strokes — and takes the very odd approach of appending his replies, separated by a line of asterisks, to the three negative comments that dared to challenge his post.

Where should my criticism start?

A decent kickoff would be to work backwards through his straw-man points. Guy’s pointing out that VC associates aren’t necessarily the best mentors and board members for startups is not only obvious, but pointless. A VC associate isn’t supposed to be the wizened old sage who shepherds a company to success; indeed, I would suggest that in most VC firms, associates aren’t even allowed to take board seats.

Guy disingenuously ignores the idea of division of labor. A quick primer on investment team roles for those who aren’t familiar with finance (from which VC borrows a lot of titles):

  • General Partner / Managing Director: A “General” or “Admiral.” Not only a full investor, but an owner of the firm.
  • Venture Partner: A “Commodore” or “assistant undersecretary of defense.” Sometimes acts like a GP / MD, in other firms is more like a part time advisor.
  • Principal: A “Captain” or “Colonel.” Able to take board seats and have one’s “own” investments.
  • Associate: A “Lieutenant.” Might lead deals, but doesn’t “sign checks.” Not usually on boards.
  • Analyst: An “Ensign” (or maybe a sailor). Helps with deals and “bird-dogs” leads, but doesn’t do deals. Definitely not on boards.

Associates and analysts are generally MBA or pre-MBA types, and are expected to do much of the due diligence, financial modeling, and to follow up on the colder end of the lead spectrum (all the way down to cold calls, in some cases). In effect, they are doing exactly the work that their MBA, I-banking job, or consulting gig prepared them to do: spreadsheets, ginning up pitch books for LPs, reading of contracts and term sheets, talking to people and vetting their credibility, sanity-checking business models, etc.

It is at the GP / MD and Principal levels that advising of portfolio companies comes into play. (Now, will you in practice see overzealous associates running their mouths in situations they shouldn’t? Of course; in the mix of ambitious people you hire associates from, you’ll get some arrogant and / or impudent overachievers. But it’s the exception that Guy takes for a rule.)

And, if anybody is making the mythical $500k salaries, it’s folks in the GP / MD bracket. But don’t take my word for it; you can make a reasonable estimate of GP salaries for a given firm. Simply multiply the total assets under management of a VC firm by a reasonably high management fee (say, 2.5%) to find a credible upper bound for the firm’s non-carry revenues (ignoring for the moment “franchise” firms that essentially license their brands to others). Then, take a slice off the top (say 25% minimum) for rent, support staff, auditors, lawyers, insurance, and any “private jets” that Guy imagines, and you’ve got the total allocable to investment team compensation (salary, benefits, etc.).

Let’s take Guy’s firm, Garage Technology Ventures, for example. They’ve raised a first fund rumored to be $20M (with CalPERS as the “principle [sic] limited partner”), and possibly a second fund. Let’s assume that there’s a second Garage fund of $40M. That would bring total AUM to $60M; 2.5% fees would gross $1.5M annually for the firm. Let’s slice off 25% for rent, etc. — now we’ve got $1.125 M. Garage has three MDs and two VPs (venture partners); let’s assign the MDs 3x the salary of the VPs (who are probably part-time). That gives us 11 units of salary from the $1.125, or roughly $300k per MD and $100k per VP. Don’t forget that a chunk of that goes out the window to the employer costs of payroll taxes and benefits, so you’re probably looking at base salary to the MDs of more like $200k and to the VPs of perhaps $75k.

That took about three minutes (and I don’t even have a Wall Street I-banking background!). Admittedly, Guy’s firm is a remarkably small VC in terms of assets under management. Still: would any sane ex-banker think he has a shot at $500k base by going to work for Guy or any other VC?

Clearly, nobody is asserting these silly ideas (except Guy’s man of straw). This brings us full circle back to the straw man’s original plank: that VC is a great way to learn entrepreneurship. Well, precisely, this is false, and we must grant Guy that concession. There are a thousand things an entrepreneur must do that a VC associate, no matter how duly diligent he may be, will never observe him in.

But merely because the VC vantage point is insufficient to learn entrepreneurship does not mean that it cannot be helpful. Indeed, to the extent that raising investor capital (from someone other than your inner circle) is something you foresee doing, being on the VC side of the table is remarkably helpful. I speak from experience here: I roughly bootstrapped two startups using a combination of the five F’s: Friends, Families, Fools, Physicians, and Float (off of credit card convenience checks!). Yet my knowledge and ability concerning raising investor capital was nil. After my time so far at Voyager, I now have a relatively huge sample size to see what works and what doesn’t (and why!) in investor pitches.

Now: if I had spent the last two years pitching VCs, would I have more and different knowledge about entrepreneurship than that which I gained listening to such pitches? Certainly. And it’s almost undoubtedly better for the skill of raising capital to actually practice raising it than to observe others pitching you. But to the 25-year-old entrepreneur without a “base hit” or previous connection to the venture industry, practicing raising VC by just doing it isn’t ge
nerally a realistic option.

Guy also ignores the fact that a VC is supposed to be different from an entrepreneur. They operate on different logical levels; a VC must be at a meta-level to the entrepreneur’s. Meta-level occupations, such as consulting or I-banking, prepare individuals for this by having them view many businesses and compare among them for patterns, valuations, etc. It’s the difference between being an antiques appraiser and being Carl Faberge.

A better and more useful caveat to young VC position-seekers is simply to remark on the dearth of positions available. There are, to a first approximation, no jobs in VC. If VC wants you, it’ll find you; if not, you’re almost certainly better doing something besides quixotically questing for a junior venture job.

That said, I chose VC as a detour on my route to entrepreneurship. Although I wasn’t originally looking for VC as a next step, it was recommended to me by one career advisor around the same time as I learned of an open position looking for an analyst with operating experience. The money isn’t princely, but it’s steady. The learning isn’t everything I’ll need to succeed, but it’ll help. And frankly, it’s absolutely a blast and the next best thing to starting my own new company.

A final note: a subtext to Guy’s entry and its comments implied that junior VC personnel were all young whippersnappers who couldn’t hold a candle to the grizzled but worldly wise entrepreneurs they worked with (and that they ought to hold their tongues besides!). That thought is OK, I guess: I certainly am humbled when I have to communicate a pass to a repeat entrepreneur who’s sold more companies than I’ve founded. But seriously: if you’re a tough, worldly entrepreneur who gets offended by talking to some young VC associate, you need to suck it up and give less of a shiitake about what us whippersnappers say.

Earnings Calls in a Trippy Vortex

Today, I called up a news release on finance.yahoo.com for a fairly dodgy publicly traded company. Although I expected to find a transcript of the earnings call, or perhaps a brief table summarizing the expected and actual earnings numbers, I was given a link to the full audio of the call.

When I clicked the link, a full-screen window of Windows Media Player popped open and started playing the earnings call, with a huge, trippy, psychedelic vortex being rendered in the middle of the screen!

(As it happens, a mind-warping black hole of profits is the most appropriate metaphor for what this earnings call was all about.)

Thanks for a bit of inspired weirdness, Microsoft. It was certainly more enjoyable than discovering that your flagship email client can’t “archive” two folders at once.

VC Annoyance: Term Sheets Excluded from Closing Book

The Closing Book of a financing is the definitive collection of all documents relied upon in conducting a financing. It will generally have a “snapshot” of critical documents before and just after the financing, such as the original Articles of Incorporation dated one day, and the “amended and restarted” articles dated the next. Other agreements such as Investor Rights Agreements and Stock Purchase Agreements are included as well.

However, much to the chagrin of analysts like myself who often have to go back to the closing book for reference purposes, the actual term sheet often is not included in the closing book! This is most frustrating, since as a practical matter it is usually more relevant to discuss “term sheet to term sheet” when comparing terms or negotiating a subsequent round, rather than referring to definitive legal documentation (I estimate that the ratio of words and pages in a term sheet to those in the definitive docs based upon the term sheet is around 1:250).

I believe this is because attorneys are loathe to include anything in the closing book that might give even a thin entering wedge of challenging the definitive docs. Specifically, if a term sheet is included, a party might contend that the term sheet was the “parent” of the documents that followed, and should therefore inform the interpretation or construction of the definitive docs.

This may be a legitimate concern, but damn it, lawyers, couldn’t you just stamp: “non-binding, subject to the definitive documentation” in red all over the term sheet and stick it in the closing book??

To the sender of an unsolicited business plan email

2006-06-08 Randall Lucas Hello, I received an unsolicited business plan via email from you. This letter will try, in a constructive and humble manner, to tell you why I won’t read it, and what else you should try. Unsolicited commercial email is spam — even if it’s sent to twenty VC firms instead of a million random people — so I use that word to describe it here. Spam is costly but those costs are unfairly split. An email costs the sender nearly nothing on a per-recipient basis, but instead places all the cost (of time and attention) on the recipient. If VC firms made a point of reading business plan spam, it would effectively reward the senders of spam, and thus perpetuate the problem in a vicious circle. So, those of us who work for VCs must — for both moral and time constraint reasons — relegate unsolicited business plan emails to the “Trash” folder. However, in the spirit of constructive criticism, I want to point out some good alternatives to business plan spam for getting a VC to look at your plan. These are solid ideas that have worked for firms pitching my employer, [http://voyagercapital.com/ Voyager Capital], but may not be applicable everywhere. – Build your team in-house. It will be very hard to successfully raise VC funding without at least one person in your management team who hsd experience with venture-backed startups (and therefore, at least some connections in venture capital). If you’re having trouble getting seen by VCs, you should consider teaming with someone who has done it before. – Find quality “Angel” investors. Angels (high net worth individuals) often have connections to VC firms and try to parlay their initial investment in your company by introducing you to VCs they may know. While your best bet here is to find angels who are personally connected to you or interested in your product, you could also look to organizations like these: * [http://www.allianceofangels.com/ Alliance of Angels] * [http://www.k4seattle.com/ Keiretsu Forum] – Hire top-notch service providers (lawyers, accountants, consultants). Hiring a “brand-name” lawyer or other service provider often gets you limited access to his Rolodex. The Holy Grail of this route is to find a well-connected service provider who is willing to take equity for payment; his cash flow then depends on your successful fundraising. I hesitate to name names here, but some good signs might be having a Silicon Valley office, reaching out to the entrepreneurial community, or having been the service provider on well-known deals in your industry. – Get out the door and network. VC folks, from general partners down to lowly analysts such as myself, can often be found at technology and business networking events. Here in Seattle in the last few months, I’ve personally spotted other VC folks at events ranging from the [http://www.techcrunch.com/2006/06/01/two-parties-in-two-weeks-seattle-and-london/ TechCrunch / Redfin / TripHub / Farecast Party] to the [http://www.nwen.org/ NWEN Venture Breakfasts] to the [http://blog.seattlepi.nwsource.com/venture/archives/101645.asp PaidContent.org mixer]. Many of these events are free or of nominal cost. This route is easily the best way, since everyone who works in the Seattle VC community is not only good-looking, charming, and witty, but also a pleasure to talk to (ok, in any case, most of us don’t bite). Please note that one thing I did not list is hiring a firm specifically for fundraising purposes. While there may be some situations where hiring a fund finder is appropriate, in most cases, a promising business should be finding VC connections through one or more of the above routes. Remember, in business as in life, you are often judged by the quality of the company you keep as much as by anything else, so having an introduction from a trusted party is the first step to winning the VCs’ trust. Finally, while many VCs don’t explicitly rule out investments brought through a paid fundraiser, they tend to be wary of investing money to be spent on a finder’s fee, rather than on growing the business. (Arrangements where VC introductions are incidental to a consultant’s substantive work on growing and shaping the business are generally viewed more positively.) I hope this note has helped you to understand why your unsolicited business plan will not be read, and how you can go about making the sort of personal connection that will maximize your chances of getting a good deal funded. Best regards, Randall

Unsolicited Emails and VCs

2006-06-01 Randall Lucas About a month after starting to work for Voyager Capital’s investment team, I started noticing a different kind of spam email than I had ever received in the past: business plan spam. This problem — probably fairly unique to VCs (and possibly high-profile angel investors) — exhibits many of the same characteristics as “normal” spam: – Sending these spams, on a per-recipient basis, is cheap or free to the sender. There are ~ 700 venture firms with Web sites in the US; scraping or guessing the addresses of people at those firms is fairly trivial (remember, most of these spams are from ostensibly “cutting edge” software companies; writing a screen-scraper is a before-lunch type of project for a competent programmer). – Receiving these spams imposes a cost on the recipient. VC is already an ADD-riddled industry; it would only be humane to respect what little concentration and attention your average VC has left. – The senders acknowledge that the “payoff” event (making a sale, or in this case, securing an investment) is exceedingly rare, but figure that at so low a cost, it’s worth it even at a tiny payoff probability. – For a product or business plan, being advertised in a spam email correlates remarkably well with being low quality. In addition to these similarities, there are a number of other characteristics of business plan spam, some of which make it more pernicious: – Business plan spam is eerily closely targeted. For one thing, there are only a few thousand VCs in the US, so it’s kind of like some stranger knowing that you were born in a particular small town. For another, many of these spams manage to include the recipient’s name, in a pseudo-personalized way. Business plan spam is just anonymous enough to be disrespectful, and just personal enough to be unsettling. – The VC community this spam targets is small and runs on personal relationships. Offending a colleague or possible business partner in this small world is a big deal. Since it is possible, though unlikely, to misinterpret an email as unsolicited, and since accusing someone of spam has the potential to offend them, I believe VCs are loathe to reproach senders of business plan spam. (Much like the spammers themselves, VCs are faced with a low probability but high [negative] payoff event of offending a legitimate referral.) – Oftentimes, perhaps because the senders of the emails are poorly indoctrinated with good Internet culture, they think that they are behaving within appropriate norms. This leads to a number of behaviors, such as being very free with the number of emails they send, and taking umbrage at the lack of a prompt reply. Finally, further complicating all of this is the fact that sometimes (though rarely), a business plan that might otherwise be judged worthwhile, if referred through a trusted channel, comes in through the spam channel. Admittedly, it is unlikely that a partner-level VC would remember a spammed business plan well enough for it to hurt the company’s chances of funding. However, associates, analysts, or gatekeeper support staff who may have had to deal with a spammed business plan (sometimes repeatedly!) could have a lot to do with those chances, and annoying them is therefore bad practice. Entrepreneurs should keep in mind as well that “hired guns” for fundraising have a wide range of levels of quality and soundness of practice; I’d estimate that nearly half of the business plan spam I receive is from a paid fundraiser rather than from a company principal. My reason for explaining all this is by way of introduction to another document I feel needs to be written: a respectful explanation of why spamming VCs is a bad idea, and some constructive suggestions on how to approach them (us) through channels that ultimately work better for both parties.

Venture Capital Jargon and Terminology

2006-04-10 Randall Lucas

It’s been just over half a year that I’ve been working on the “other side of the table,” as a VC analyst at one of Seattle’s leading venture firms. Something that was helpful to me in my first days on the job was reading blog postings from Brad Feld and Fred Wilson, explaining terms of art in the VC world, like “participating preferred,” “liquidation preference,” and the like.

Both as a personal reference tool, and in order to help out folks (be they new analysts / associates at a venture firm, or entrepreneurs) who are faced with rapidly coming up to speed on the jargon of the industry, I’m preparing this miniature glossary of VC terms. I’m targeting the reader who’s responsibility is actually modeling the effect of these terms once in place, rather than negotiating them ex ante, so commentary is biased accordingly.

Antidilution Protection

A right of preferred stockholders to increase their effective number of shares in the event of a subsequent dilutive (lower per-share price) sale of stock. AKA “the (full or partial) ratchet.”

For preferred stock, antidilution protection is usually effected by an adjustment in the conversion price (or ratio). For example, if you bought at $1.00 per share, you would normally convert to common at $1.00 per share (1:1 ratio). For reasons of antidilution, your conversion price might be adjusted to $0.75 per share (1.5:1 ratio). How this is calculated depends upon the type of protection.

Antidilution protection is usually either “broad-based” or “narrow-based” — these represent the “partial” ratchet, and are based upon a weighted average. In broad-based antidilution protection, you would typically reduce the conversion price using a factor derived as follows:

         Old share count (CSE) + (New money / Old per-share price) Factor = ---------------------------------------------------------          Old share count (CSE) + (New money / New per-share price)  (Broad-based antidilution conversion price factor calculation)  

For narrow-based protection, the factor is derived similarly, but instead of CSE for the old share count, a much smaller number may be used (such as only the then-outstanding common shares). Investors naturally prefer narrow-based to broad-based when choosing a weighted average antidilution clause.

However, the rational investor will prefer most of all the “full ratchet.” This clause simply adjusts the conversion price on the old shares to the new share price. In the event of a “down round,” this jacks up the prior investor’s percentage ownership in a major way.

In fact, however, the “full ratchet” is not aggressively pursued by many VCs these days. Although it is theoretically favorable to him who holds it, it paradoxically may turn off a subsequent “down round” investor and wash out management’s skin in the game at a time when that capital and talent are most needed.

Carveout

A distribution upon liquidation which is set aside (“carved out”) for the management team, often at the discretion of the Board of Directors and ahead of equity distributions.

One purpose of a carveout is to ensure that management stays motivated to effect an orderly wind-up of a company even when their equity compensation is likely to be modest or nonexistent.

Other sources: Gray Cary

Common Stock Equivalents (CSE)

The number of common stock shares for which a given security may be exchanged or converted; includes things like preferred shares as-converted, options, and warrants. However, it behooves the analyst carefully to read the documents in question; varying types of calculations calling for the fully diluted share count may have differing rules (e.g. for options, one might count all authorized, only granted, or only “above water”).

Dividends

Preferred stock often has a dividend clause; a typicaly amount and character of dividends I’ve seen is “8% annual, non-cumulative, in preference to junior stock, when, as, and if declared.” The last part — if declared — is the key issue here, since dividends rarely if ever are declared by startups.

The consensus I’ve gotten in this part of the country is that dividends are typically a non-issue, but that a dividend clause is added to block shenanigans such as a dividend to common shareholders to circumvent the liquidation preferences.

Sometimes, preferred stock will have a mandatory dividend associated with it as well; this is more likely to be seen in mature companies than in startups, and I have never had to model it. This might also be different in different regions.

Drag-along Right

The right to compel other shareholders to approve a liquidation transaction (“drag them along” with you). Usually afforded to a supermajority of preferred shareholders (either a specific class, or preferred holders voting together).

(Update 2006-06-19: Brad Feld introduces his readers to a variant of a drag-along right, termed a “compelled sale right,” in which the right is attributable to a particular minority shareholder rather than a majority or supermajority. Shockingly, in Feld’s example term sheet, this compelled sale right is given to a 10% CSE owner.)

Liquidation Preference

A right of holders of a series of preferred stock to receive, before any other distribution, a specified payment, typically a multiple (such as 2.0x) of the original purchase price. AKA “two times money out first.”

Liquidation preferences are either paid in rank order (e.g., Series D preference first, then Series C, then Series B, etc.) or pari passu (according to each series’ percentage of the total preference amount). Once all the preferences are paid, then the rest of the proceeds are split among the holders of common stock (but see Participating Preferred, below).

The choice of converting to common vs. taking a preference, in a multiple-series capital structure, can lead to some pretty hairy financial models; caveat Excelor. One big thing to remember is that the decision of one series can “cascade” to others, since the first series’ decision, by definition, will be changing the amount of proceeds available to others.

Very rarely, common stock has a “liqudiation preference” as well (no joke — I’ve seen it with my own eyes!).

Other sources: Brad Feld on liquidation preferences;

Participating Preferred

A series of preferred stock which, in addition to any liquidation preference, gets to participate in the distribution of proceeds to common stock on an “as-if converted (to common stock)” basis. AKA “double dip.”

In non-participating preferred, a preferred investor must choose either to receive his liquidation preference, or to participate on an as-converted basis. For small exits, the preference is better; for large exits, the participation is better. Participating preferred is known as the double dip, because the investor gets both.

Sometimes, this clause is combined with a “cap” on the participation amount, which is, in a tricky way, equivalent to non-participating preferred with a big “invisible preference” included (because the investor still faces a “tipping point” where it is better to convert to common; it’s just a much higher number).

Other sources: Brad Feld on participating preferred;

Redemption Right

The right
of a stockholder to require the company to buy back his shares. Like with dividends, this is almost always present, but very rarely invoked for startup deals.

Typically, the redemption right specifies the price of redemption and a timeline (e.g. 1.0x, monthly over two years). Most often, this right requires some kind of supermajority of preferred holders for its exercise.

Warrant Coverage

In conjunction with another financing, the issuance of warrants to purchase stock in a quantity usually specified by a percentage of a principal amount (e.g., 10% coverage on a $5 M bridge loan would be a warrant to purchase $500k of stock). The actual price for the warrant exercise might be the then-current price, or it might be dependent on the conversion price of a convertible note.

Warrants are usually “sweeteners” added onto debt rounds by venture lenders; chances are awful good that if you look at the warrants section of a few cap tables you’ll come across “SVB” before long (Silicon Valley Bank, one of the usual suspects in venture lending).