New financing tools

First they ignore you. Then they laugh at you. Then they fight you. Then you win.”
Mahatma Gandhi

I hesitate to use a quote from one of the greatest people ever to grace planet earth, and certainly the question of how to structure early stage investment is a laughable cause as compared to the rights that Ghandi (also a lawyer) fought to advance.  That said, I think this quote accurately captures the life-cycle of creating a simple set of documents for early stage investment.

I’ve attached version 2.0 of the Series Seed Documents as well as a red-line showing the changes I’ve made from the original set.  If you peruse the red-line, you will see that there are not many changes.  That’s because there are not that many issues to negotiate in a simple equity financing.  Of course, one could argue, that I’m just not taking comments I disagree with (or that nobody cares enough to comment), but I am of the opinion that these documents represent the 95% consensus of what should be in a very basic set of equity financing documents.  Based on the comments received, both on the blog and in the many deals in which these documents have been used, I am convinced that the terms of a simple set of equity documents are really not an issue.  I don’t mean to say that the Series Seed are infallible, but there are no major objections to their content.

http://znacomstva.blogspot.com/2011/05/new-forms-of-startups-financing.html

The Marc Andreessen VC rules

VCs do things that Marc Andreessen really don’t like. 

1. They are fake casual

A lot of VCs dress casually, speak casually and encourage the companies in which they invest to have casual board meetings and casual discussions with investors. They say things like, “We’re part of the team with you and we’re building this together, so no need for formal behavior, formal thinking, or unnecessary preparation.” This would all be terrific—if it were actually true.

In reality, the entrepreneur is building the company, and I’ve yet to see a VC who shows up in the company’s office at 8 am and works until 11 pm 7 days/week, so no: they are not “part of the team”. More importantly, VCs invest other people’s money into their companies and have a strong fiduciary responsibility to make sure that the entrepreneurs run their companies properly. Sure, casual board meetings might be fine as long as the company is delivering terrific results. However, at the first sign of trouble, I hear things like:  “The founder is not really capable of being CEO. He doesn’t even present critical information in an organized fashion at the board meeting.” Well, maybe he would have done that had you not instructed him to “keep things casual”.

As an entrepreneur, you should take board meetings seriously because board meetings are serious. If one of your VCs implies that board meetings aren’t serious business or that they prefer that board meetings be primarily open-ended discussion, you should view this as a 5 year-old child requesting complete autonomy and unlimited candy—that may be what they are asking for, but what they really crave is structure.

2. They want to grab a cup of coffee

Some of my best friends are VCs, and I am always happy to see them. Some VCs have important business to discuss with me and I look forward to those meetings. Some VCs are extraordinarily smart and meeting them is educational, and I am grateful for their insight. However, many VCs who want to have coffee with me are none of the above. Worse yet, they have no agenda and no purpose. They just want to “compare notes.”

When I was CEO, I didn’t take meetings with no agenda and no purpose. I’m not sure why I should take them as a VC. Of course, when I was CEO, people knew better than to request a meeting with me with no agenda and no purpose. I think that these VCs have mammas that didn’t raise them right.

More importantly, VCs having coffee with one another is a key conduit for VC groupthink.  This is how you get 30 venture-backed startups going after the same market at the same time.  It’s bad news for VCs and it’s bad news for their companies.

My proposal: less coffee, more original thinking.

3. They confuse pattern matching with knowledge

As a VC, I have come to understand the value of “VC pattern matching.” Experienced VCs have been on dozens of boards and seen thousands of deals. As a result, they recognize patterns of strategy and behavior that generally work, and patterns that generally fail. This is very valuable information for an entrepreneur who, if lucky, only sees one deal in his career.

Unfortunately, many VCs overreach with their pattern matching. Rather than saying, “Most companies who sell at this stage, regret doing so, and here’s why,” they’ll say, “Don’t sell now, that’s a stupid idea.” Other commonly expressed and incomplete patterns include “don’t hire very fast”, “hire faster”, “don’t build a sales force”, “build a sales force”, “don’t build downloadable software”, and “build an iPhone app”.  None of this is useful input for your specific company.

A pattern-matched instruction without a rationale provides very little help. Either admit that you are pattern matching and that pattern matching is limited, or explain yourself.

4. They are pseudo-tough

VCs often confuse marginal social courage with real courage. For example, they think CEOs who fire people easily are tough. I’ve fired dozens of people and laid off hundreds. None of them was easy—not a single time. Having an easy time firing your loyal employees indicates a lack of courage and a lack of leadership. More specifically, it indicates a lack of willingness to really understand the negative consequences of those actions. If you fire people easily, you likely lack the toughness to look in the mirror.

VCs who value pseudo-toughness often display it themselves. I see them bully entrepreneurs by directing them to do things without having the intellectual courage to explain “Why?”. They berate the CEOs in their companies, but don’t have the cojones to stand up to their own senior partners. They undermine their own CEOs in their own companies by interfering with important decisions, but don’t have the moral fortitude to even tell the CEOs that they are doing it.  These behaviors are not tough; they are pseudo tough. Pseudo tough VCs really annoy me, and damage their companies in the process.

If you are a VC and want to be tough, be real tough.  For a VC, real tough is:

• The strength to explain in detail to an entrepreneur what she is doing wrong when the company is doing well, in order to improve her performance.
• The courage to do what’s right even if it makes you look really weak to the partners in your firm.
• The valor to tell an entrepreneur precisely why you are not going to invest in her company rather than giving the traditional “VC no” by just going dark.
• http://blog.pmarca.com/2010/04/13/what-some-vcs-do-that-we-dont-like/

Start-ups valuation

If you're a new/small angel like myself with a fixed investment pool, what can you do to maximize the # of deals? Two things really. First, make smaller investments--though this isn't great because there's a lower limit where you'll get shut out of deals ($25K is probably the realistic minimum) and, when you do hit, you won't get that much back.

Second, liquidation preference. In my previous post on angel investment scenario planning, I noted that small returns (1-3x) don't influence overall deal pool IRR that much. And that's true in a static scenario. But the real world is dynamic and if you can do more deals you can increase the chances of hits, as noted above. Getting money back through liquidation preference won't move the IRR needle, but it will enable you to do more deals. And to the small angel (me) that is the most important thing.

If you have no idea what liquidation preference is (and you want to know!), check out Brad Feld's two great introposts on the subject. The default term from the Series Seed Term Sheet is essentially "One times the Original Issue Price." That means in an exit event, the investors have a choice to a) get their money back or b) get their equity %. It's an economic choice. If it's a small exit and the equity % doesn't yield as much money as was put in, you'd opt to get your money back; otherwise, you'd opt to get your %.

Tweaks on this model are:

• Get multiple times your money back (e.g. 1.5, 2 or 3 times) in choice a.
• Get your money back first, and then also participate in the distribution of what's left based on your %, which is called participating preferred.
• Participation, but with a cap. In this one you participate up to a limit, like 3x. So you get your money back, and then your % allocation, but if that exceeds 3x your money you have the choice whether to get that or your straight %.

Startup valuation

What valuation is better? Cash flow multiple basis or IRR?

IRR takes into account those returns over time. In other words, a huge payout after a long period of years can work out to a lower IRR than smaller, but quicker, payouts that end up returning less cash overall to investors.

Superangels, like VCs, raise money from institutional investors called Limited Partners (LPs), like big banks, pension funds and university endowments. And these LPs don't just invest in venture funds, they invest over a very large range of asset classes, from the pedestrian (stocks, bonds) to the exotic, like private equity. LPs use IRR to compare the returns over all these different asset classes, and professional venture investors, whether traditional VC or superangels, need to have a better IRR than those other investments. Superangels with better IRRs can raise bigger funds and/or demand higher fees.

By focusing on the speed, and not just the size of the exits, superangel funds can give much better IRRs to their investors than most traditional VCs. (Paul Graham made that point here.)

And the macro environment favors this, too. Companies take forever to go public now which, all else being equal, will lower VCs' IRR. Meanwhile it's much easier for superangels to sell their stakes in big startups through secondary sales and/or DST-type deals.


Detail about startups market valuation http://znacomstva.blogspot.com/2011/04/vcs-has-largest-quarter-since-2001.html