Posts from February 2011

M&A Issues: Reps, Warranties, Indemnities, and Escrows

Yet another post on issues in M&A. This one is about the things you will sign up to when you sell your business and the money you will set aside to cover them.

First things first. I am not a lawyer. And this post is about legal stuff. I barely know how to spell indemnities. I had to double check that I was spelling it correctly. So I am going to put a bunch of stuff on the table but if you really want to understand this, talk to a lawyer. This kind of stuff is why you have a lawyer and why they are valuable. That said, here goes.

When you sell your business you will make a bunch of representations to the buyer (reps). You will tell them you own all of the assets you have on your balance sheet. You will tell them that you have no more liabilities than you have listed on your balance sheet. You will tell them that you own all the intellectual property you claim to own. You will tell them that you have all the contracts with customers you claim to have. I could go on and on. The list of reps in a purchase agreement is long.

This is a contract. You need to take this stuff seriously. If you are repping to something, you should be very careful and read every rep and make sure it captures the situation accurately. There will be schedules for most, if not all, reps. Read them too. You are making promises to the seller. Make sure they are correct.

Reps are about what is true today. Warranties are about the future. You will also be asked to warranty a number of things in a sale contract. Read them carefully as well. Make sure you are confident of them. Lawyers write these contracts but people have to live up to them. So don't just treat a contract as a piece of paper to be signed. Understand what is being agreed to, take the time to understand it. If you don't understand it, make your lawyer walk you through it, line by line if need be.

An indemnity is the amount of money that is to be paid from the seller to the buyer if any of the reps and warranties turn out to be false. They will be set up in the contract. Understand how much liability you are taking on for the reps and warranties.

The buyer will require a percentage of the purchase consideration be set aside to back up the indemnities, usually for one year. The percentage is most often 10%, but can be more or less depending on the type of deal it is. The escrow is the money the buyer can come after based on the indemnities without having to sue the seller.

There will be an escrow agent represeting the selling shareholders. It is most often the lead investor. Our firm has done this many times. It is a thankless task, but an important one. If there is a fight over the escrow amounts or a larger claim, the shareholder representative will be the one dealing with the buyer.

One area that has been particularly problematic in M&A for tech startups is IP reps, particularly patent issues. An announcement of a large purchase of a tech company is a big fat target for patent trolls. The patent infringement suits will come out and the seller's escrow will be the target. My partner Brad has been dealing with one of these for years. It is ugly.

Most of the time, the escrow is paid without much haggling by the buyer on time (usually a year later). But sometimes the buyer has legitimate claims and the escrow is used up paying the indemnities. It is rare (at least in my experience) for the buyer to come after more than the escrow. That is most common in outright fraudulent transactions.

In summary, you will be asked to make a bunch of statements of fact and future performance to the buyer when you sell the company. Take them seriously and make sure you understand what you are signing up to. Be prepared to set aside at least 10% of the purchase price to back up these statements. And if things go wrong, expect to lose some or all of that 10%.

#MBA Mondays

Marketing and The Bubble

Rand Fishkin has a good post in response to my marketing posts over the past two days. In it he makes this assertion:

For the first few years that I was in the "web world," 1997-2001, there was a dangerous and obvious bias in startups toward sales and marketing – and branding in particular. But, in the past few years, that pendulum has swung to the equally dangerous paradigm that product is everything.

And then he shows this great graphic:

I totally agree with Rand that VCs and entrepreneurs learned the hard way in the last bubble that spending a ton of money on marketing didn't guarantee success. More likely it guaranteed failure. And I am certain that experience has caused me and my partners to view marketing oriented startups with a fair bit of caution.

It may also be true that the same VCs and entrepreneurs have gone too far in our collective disdain for marketing. That is essentially the argument Rand makes in his post and he makes it well, with some cameos by USV portfolio companies.

Another post written in response to my marketing post is this one by Alan Patrick. Alan paints a different picture. He doesn't see the pendulum swinging away from the behaviors of the last bubble. He sees it swinging back toward them:

One of the things that defines a bubble is that too much money chases too few assets (in this case decent startups) – but the market abhors a vacuum, so the next thing is a flurry of production of new (me-too startup) assets to fund – so more startup teams leaving MBA school, more First Tuesdays, more Incubators, the start of funding at silly values "off the slide deck" – and it means a vast increase in startups also scrabbling around in the darwinian mire that one has to kick off the slippery ladder to get one's own hands on the rungs – and that means more and more shouting.

More shouting certainly isn't the kind of marketing I want to fund, and it is exactly the kind of marketing we all funded in the last bubble.

I'm sitting here mulling over the irony of two very different reactions to the same post, both of which I'm in agreement with. We are in a challenging phase in the cycle for sure. And marketing is a weapon that startups will need to use to get noticed in a very crowded and competitive environment. I just hope they use it smartly and well.

#VC & Technology

Marketing Post - The Bug Report

Yesterday's marketing post had a few bugs in it. The AVC user base did a lot of bug reporting in the comments and if you have an hour or more, you should read through the entire comment thread, at the end of the post.

The first and most important bug is that I dissed the marketing profession at the start and again at the end of the post. Seth Godin says I conflated marketing and advertising. I don't totally agree. I simply disrepected marketing and then went on to talk about how to do marketing. Not a great way to have a rational conversation about marketing.

The second important bug is that my advice holds mostly for the kinds of companies we seek to invest in. I did a decent job of explaining that in the post but I could have done a better job of it. We seek to invest in large networks of engaged users on the wired and mobile web. This largely means big breakout companies in the free consumer web. It does not mean ecommerce, saas, enterprise, or plumbers (as one commenter pointed out).

The third important bug is I gave a bunch of advice in an area I don't have a lot of operational experience in. I've never been a marketer nor do I ever want to be a marketer. But I have seen what has worked well for our best performing companies. I should have been more clear that I was sharing what I've seen work for our portfolio instead of giving broad marketing advice.

There are a host of other smaller bugs and you'll see me reacting to them in the comment thread.

I'll end this bug report by saying that I still think the kinds of companies we want to invest in do not need to have marketing budgets at the startup phase. And I'll also say that I have seen "marketing professionals" do a lot of damage to our portfolio companies over the years. Most of the damage has come from outsourced marketing relationships with agencies who charge too much and help too little. But I will also say that marketing hires in our companies have had the lowest succcess rate of any hire and there are many so called experts who have turned out to be bad and expensive hires.

I'm angry at the marketing profession for these transgressions over the years and it spilled out into my post. I'm not proud of that but it is what it is. The post stands as written with all of its bugs and an awesome comment thread at the end.

UPDATE: There is one other thing I want to mention about the original post. I totally left out customer service. That is possibly the single best way to do marketing for startups. It allows you to connect to your early users, learn from them, and turn them into advocates for your product or service. Yet another bug in my original post.

#VC & Technology


You asked for it Arnold and 84 others (so far). So I'm gonna talk about marketing.

I believe that marketing is what you do when your product or service sucks or when you make so much profit on every marginal customer that it would be crazy to not spend a bit of that profit acquiring more of them (coke, zynga, bud, viagra).

A very experienced and successful entrepreneur came into our office a week ago to pitch his latest company. At the end of his pitch he showed us some numbers. Normally for a raw startup we see almost all product and engineering expenses (headcount). But his plan had a monthly budget for customer acquisition. After he left, we talked about his plan and my partners focused on the customer acquisition number. It bugged us. It felt wrong.

So a few days later, I called him. We talked about what we liked about his plan and pitch and what we didn't like. I brought up the customer acquisition line item at one point in that call. He said "every company needs a marketing budget." It seemed like a strong reply but in truth not one of our top performing companies had a marketing budget in their initial business plan.

Zynga has spent millions on customer acquisition and continues to do so. But in the beginning, when Zynga was three or four people and they launched Texas Hold'em on the brand new Facebook Platform, they didn't spend any marketing dollars. That was the beauty of that time and that plan. The Facebook Platform was free distribution. Zynga rode that free distribution to millions of users, profits, and additional games. Only then did they start marketing.

In my talk at Harvard Business School, I said "Early in a startup, product decisions should be hunch driven. Later on, product decisions should be data driven". I've seen that line tweeted a thousand times since then. Clearly people like that rule. Here's another.

Early in a startup you need to acquire your customers for free. Later on, you can spend on customer acquisition.

So if you need to acquire customers for free early in a startup, how do you do that? There is no one right answer, it depends a lot on who your customer is and how hard the sell will be (consumer/enterprise and free/paid). I'm not an expert on enteprise focused SAAS businesses. I am not going to address that part of the market here.

For the consumer/free part of the web, there are some obvious things you will want to do:

1) Twitter – so many entrepreneurs have asked me "how did you start a company before Twitter?" Twitter is that free distribution that Zynga got on the Facebook Platform. You can and should get the word out about your product/service on Twitter and Facebook. You should encourage your friends to post about it, retweet about it, and encourage people to try it out. The digerati hangs out on Twitter and will see the tweets and RTs and many of them will try it out.

2) Social hoooks – Your product/service must be social. It must encourage your users to invite others to try it out. Hooks into Facebook and Twitter are obvious. Email invites are another obvious feature. The product should allow people to express themselves in it. Profiles, personalization, etc will allow the users to feel ownership of the product and tell others about it. Foursquare's adoption of a game dynamic when it launched is a particularly clever implementation of a social hook. Games are the most social of all things on the web.

3) Find entry points – MySpace launched in the holywood crowd that were friends of Tom and Chris. Twitter launched in the SF tech community that were friends of Ev and Biz and Jack. Tumblr launched in the "roll your own blog" avant garde community that David was part of. Quora launched in the Facebook alumni community. Facebook launched on Ivy League campuses. You get the idea. Find an obvious group of like minded people who know each other and launch into that community. If they like it, it will spread throughout that community and eventually beyond.

4) Events – Find live events to launch at. SXSW is famous for breakouts. Twitter and Foursquare are the two most talked about examples. I worry that SXSW has become so big and so many companies are planning to breakout there now, that it can't happen anymore. We will see. But there are many live events that you can attend and galvanize users at. GroupMe did a version of that at the Austin City Limits music festival. I've heard of companies breaking out at Burning Man, The Democratic National Convention (Airbnb), and the Sundance Film Festival.

5) PR – Do not hire a PR firm to do your free marketing for you. This is a core capability you must own. You can and may want to hire a PR firm to supplement your efforts, but that's a different story. The best companies know how to become the story and work it. Being in NYC helps a lot. Foursquare is a great example of this. You can laugh at Dennis and Naveen doing fashion shoots but think about how many new users they got for doing that. It was a stunt like any other stunt they've done. And they have done hundreds of them. The media eats it up as they always need something to write about. Twitter is another example of a company that owned its PR. Biz is a master. At the same time Biz and Jack were iterating on the product, Biz was thinking about the brand, the story, the bird, the logo, the meaning of Twitter in the world. And he got out there and started telling the story. He is an evangelist and he did it so well. Twitter would not be Twitter without that effort. If you don't have a Biz or Dennis on the founding team, find someone who can do this for you. But I will say that the best PR centric startups have the "media DNA" in the founding team.

6) Search – It is not first on the list for a reason. I don't think search driven businesses are interesting. Live by SEO, die by SEO. Don't be a google bitch. But you will notice that many of the top consumer web brands are higly SEO'd. Try searching on a person's name who is active on Twitter. I bet their Twitter feed will be one of the first five results. It is for my name (if you take out dups). Flickr did this very well. So does LinkedIn and Crunchbase. SEO is something that takes time to pay dividends. But you should build your product day one to be search friendly and keep at it. You can break your SEO with product changes and be careful not to do that.

7) Developers – I've said many times that developers are the new power users. Twitter is the iconic example. By launching with an almost totally open plaform and a dead simple API, Twitter got thousands of developers to build products that had "Twitter inside." Those developers and their products pulled Twitter into the market. Soundcloud is another great example. There are a ton of apps that people use to create music and other audio experiences that have "soundcoud inside." Each and every one of those apps is a distribution channel for soundcloud. They are pulling Soundcloud into the market. So build your product as platform from day one. And once you get traction on your product, do things that will cause it to become a platform, Foursquare is doing this well. They first got millions of users and now they are developing a vibrant ecosystem of third party developers. They did a hackday this past weekend that was very successful.

8) Build a great product – I'll end with a return to where I started. Marketing is for companies who have sucky products. If you build something that is amazing (think Flipboard or Instagram or Instapaper) people will adopt it because it is amazing. And you won't have to do much marketing, at least at the start.

So that's what I got on marketing Arnold. What do you think?



I came upstairs to my office at 5:15am this morning with a simple plan. I was going to read through the comments to yesterdays post and select one and write a blog post.

5am to 7am is my writing/thinking time. At 7am, I head downstairs and wake the family.

It's 6:53 and I've just finished wading through the 344 comments/suggestions and doing my own liking/voting/replying to them.

Quora cannot hold a candle to this community when it comes to startups and technology and investing. You all are simply amazing. If anyone wants to know my secret sauce when it comes to investing, all they need to do is wade into those comments. It's a gold mine.

I promise I will get to blogging about the top five or ten liked comments. And I will aslo blog about another twenty or thirty topics in there that I particuarly liked. But my time for blogging is over today. Time to wake up the family.

#VC & Technology#Web/Tech#Weblogs

Bloggers Block

After a great run the past month, I've hit a bit of an inspiration gulf. So I'd like you all to help me out of it. I'm soliciting blog post suggestions in the comments. I want everyone to go into the comments and vote up the best ones by liking them. Then I'll take the best five or ten and use them in the coming weeks.


#Random Posts

David Karp's Founder Story

I enjoyed watching this short (~5min) video of Tumblr founder David Karp on Founder Stories.

Chris got David to talk about how he came up for the idea for Tumblr. There's this part about 1:40 in where David talks about going from designing his tumblog to designing Tumblr. That's the aha moment. So great that they captured that.

I also like the part about 2:30 in where David talks about how the readers of the first tumblogs (which were mostly hacks) really wanted their own tumblogs and when Tumblr launched they could finally have them without having to do the hard work of hacking one together. That's the two step super distribution model. Get the power users to adopt something and then the people who follow the power users will adopt it too.


M&A Issues: Breakup Fees

Continuing our discussion of M&A Issues, we are going to talk about breakup fees today.

A breakup fee is a payment made by the buyer to the seller if the M&A transaction doesn't close.

Many M&A transactions do not include breakup fees, particularly smaller transactions. But as the value of the transaction rises and the potential disruption to the seller's business increases, it is more likely that the transaction will include a breakup fee. The negotiation of the breakup fee can be an important part of the letter of intent (LOI) negotiation and there are cases where merger deals have not happened because both parties could not agree on a breakup fee.

As a buyer, you want to avoid and/or limit the size of breakup fees as much as you can. And you want to be very specific about the circumstances in which you would pay them. You can and should carve out as many reasons for a deal falling apart from the breakup fee as you can.

As a seller, you want to include a breakup fee in the LOI for a bunch of reasons. First and foremost, it is a good way to make sure the buyer is serious about the transaction. It is a lot like a down payment in a contract to purchase a home. It forces the buyer to signal the seriousness of their interest.

In addition, the merger transaction can be very distracting for the seller and the seller's management team. If the selling company goes through a prolonged M&A transaction and then the deal does not close, there can be significant negative impact to the business and the breakup fee is a way to get protected from that negative impact. However, a one time cash payment is rarely the solution to the problems that result from such a situation.

When you are selling your company, ask your lawyer right up front about the appropriateness of a breakup fee. He or she will tell you whether it is typical in your kind of transaction. The smaller and quicker the transaction, the less appropriate it is.

But don't just listen to your lawyer. Decide in your gut whether the seller is serious about the deal or not. And try to anticipate how disruptive the transaction will be to your business. If you have any qualms about the seller's intentions or the disruption that will ensue, ask for a breakup fee. And if the buyer is unwilling to include one, think hard about whether you want to do the transaction.

#MBA Mondays

Risk and Reward Are Not Obvious

I went to business school in the mid 80s. Investment banking was hot. The leveraged buyout craze was on. Junk bonds were hot. Everyone wanted to work on wall street.

I was obsessed with venture capital and had worked in a small venture firm the previous summer and had gotten an offer to work full time in venture capital for $60k per year with no bonus and no incentive comp. I also had gotten a job offer from an investment bank at $125k per year with a bonus opportunity of $250k.

Those investment banking job offers were all over the business school and almost everyone I knew took them. They all went on amazing summer vacations and showed up on wall street in September 1987. In October 1987 the stock market crashed and by December many of my classmates were out of work.

I took the VC job, made basically enough to live and work in NYC for ten years (subsidized by The Gotham Gal's income), but I did set myself up for Flatiron and then USV.

I told this story in a comment to my MBA Tuesdays post and figured it was worth posting as a full blog post. Risk is not obvious. And reward is not obvious. Don't do the obvious thing. Because I can assure you it rarely works out as planned.

#Random Posts

Some Thoughts On Public and Private Markets

I had breakfast with Alan Patricof last week. Alan is the dean of NYC VCs, he's been at this game longer than any of us. He was in the business when Intel and Apple went public.

The breakfast came about when Alan wrote this blog post in Business Insider about the problems with the IPO market. I read the post and emailed him with some feedback on the parts I agreed with and the parts I disagreed with.

We decided to have breakfast and chat about it.

My going into breakfast position was that the IPO market isn't all that it is cracked up to be. That the emerging secondary market is allowing companies to stay private longer (maybe forever) while allowing founders, angels, and early stage VCs to get liquidity. I believe that the IPO market should only be for the very best companies that can sustain value creation for long periods of time for their shareholders post the public offering. I think that is a very high threshold that most VC-backed companies cannot meet.

Alan's going into breakfast position is that we have lost our way (read his BI post for details). Back in the days of the IPOs of Apple and Intel, great tech companies would go public at low valuations, there were dozens of small market makers who would do research on the stocks, and most of the investors in these deals were individuals. Now we have markets that are largely closed to the individual investor. VC investing is largely instititional and limited to "qualified investors" (ie rich people). The secondary markets are also largely limited to qualified investors. And the IPOs these days are sold to a dozen or so large hedge funds who are also dominated by institutional investors and rich people.

Like all good discussions, we both came away with an appreciation for each other's point of view. I agree with Alan that we need a way to allow the individual investor to participate in the value creation that large tech companies can provide. And I recognize the the vast majority of people who have participated in the value creation from Facebook, Zynga, Twitter, and Groupon have been institutions and the very wealthy. That doesn't seem right or fair.

I think the SEC needs to rethink the capital market regulations and structure we have in our country. The secondary private market is a good thing and does allow great companies to stay private longer while providing liquidity for founders, angels, and early VCs. But there are issues with the secondary markets as they exist today. There are no disclosure requirements. There is little or no way for individual investors to participate. The 500 shareholder rule is creating all kinds of problems for companies. And we don't have a public market system that allows companies to be public at lower valuations with less capital raised. Alan believes we need a "new nasdaq" where companies can list for $250mm or less and have liquid markets in their stocks that individuals can participate in.

The US has a vibrant tech economy, a VC industry that is the envy of the world, and public markets that are highly liquid. We can and should stimulate the development of some additional layers of capital markets between the VC market and the current IPO market. A vibrant and fair secondary market that provides individuals some access and a new "low cap public market" are the natural additional layers to our current system. I'd also like to see more access for individuals into the VC market.

I hope the SEC is thinking about all of this. I hope they read Alan's post and this post. It is important stuff.

#stocks#VC & Technology