Posts from Investment

AVC regular Charlie Crystle asked me this question yesterday in the comments:

Fred, it might be helpful to some of your readers to explain when a startup should seek angel vs seed/early stage VC. 

If I need $250,000 to get to 100 customers, or $1 million to get to X, and I can raise both amounts from either Angels or VCs, where do we turn? 

And let's say both have significant interest, and the terms are the same, which is a better choice? (I no longer have an opinion on this, having gone both directions).

There are really two questions in here. The first is when you should SEEK angel vs VC and the second is if you have the option of taking money from both what you should do.

On the first, I believe entrepreneurs should seek angel money when their product is not yet complete, is not in the market and thus they cannot demonstrate real market traction to investors. There are multiple reasons for this and I'll try to articulate the most important of them.

A company without a product in the market is a very risky proposition. Some VC firms will invest at this stage but I am not sure its entirely appropriate for VCs to invest at this stage. Our firm will do it when we are backing a serial entrepreneur with a super strong track record that we are very familiar with. Otherwise, we stand on the sidelines and watch with interest but no capital at risk. A syndicate of angels, each with a small amount of capital at risk in the project, is a much more appropriate source of capital for a company at this stage because the risk has been well syndicated among the group.

Angels are also more hands off and I believe hands off investors are better for a company where defining, building, and tuning product is the primary exercise. VCs have a responsibility to their partners, both the partners in their firm and the partners who fund their firm, to be highly engaged in the business. So like it or not, they are going to be engaged in the business. I think it is best when that engagement is applied to a product that is in the market and gaining traction, and building the business is the primary exercise.

Finally, selling a VC on a concept on a whiteboard is a very hard sale. It is extremely time consuming with very little chance of success. Selling an angel on a concept is much easier. So simply in terms of where you should spend your time raising capital, angels are a better target in the "concept to product" stage.

The second question, what to do if you have the option of taking money from both sources on the same terms, is more interesting in many ways.

My answer is do both, if you can. When we participate in seed rounds, we most often do it by ourselves with a syndicate of high quality angels. We have done this at least a dozen times now and it works extremely well. We behave as if we are one of the angels and try to be relatively hands off. And we hope that the angels will add value just as they do in their other syndicates where there is not a VC firm involved.

But when the company needs another round of financing, we are there to provide more financing. Sometimes the angels follow in the successive rounds. But mostly they do not. It really doesn't matter, because we can fund the company on our own as long as the capital requirements are modest.

This is our preferred model and we have used it with great success. I think it benefits entrepreneurs the most as well. There are a number of VC firms that use this model. I first saw it practiced by Brad Feld about a decade ago in the seed deals he was doing in the Boulder area when he was at Mobius and I admired it immediately.

If for some reason, you must choose between VCs and angels, then I would choose a VC firm, as long as you have a very good relationship with the firm and the specific individual who will be leading the investment from the firm. In almost every situation, you are going to need more than one round and VCs can and will do multiple rounds and angels often cannot.

I will end this with a comment on the emerging seed and super seed fund models. They exist somewhere between angels and VCs and some are growing and turning into full blown VCs as I have mentioned recently in another blog post on this topic. Seed and super seed funds are "institutional angels" and as such I would mostly categorize them as angels. But many of them do have more capital at their disposal and can, at times, provide additional rounds of funding. So in some ways they are a hybrid. A syndicate of a seed fund or super seed fund and angels is a great way to go if you can put that together. A syndicate of a VC, a seed fund, and some angels might even be better.

To finish this post, I think entrepreneurs should target angels and seed funds when they are pre-launch but if they have the opportunity to pair a VC firm with angels and seed funds into a single syndicate they should do that because it will provide most stable funding platform for the business going forward.

Our portfolio company Foursquare closed a second round of financing yesterday. This was a much covered financing process and also much criticized. I think it makes an excellent case to talk about some conventional notions and why they might not be right.

Back in the early spring Foursquare decided that it needed to raise more money to support its growth, both service growth/scaling and team growth. Foursquare identified about a half dozen venture firms that it thought would be ideal investors and opened discussions with them. A few backed out of the process because they had investments in competing businesses. But all of the other firms were eager to make an investment. The Company could have closed a financing at a very attractive valuation in two or three weeks if they had chosen to.

But as they kicked off the financing process, a fair bit of acquisition interest in the company materialized. So the founders made the decision to dig into what those transactions might look like. They spent the better part of the spring doing that and eventually determined that staying independent was the best thing for the service, the user base, the team, and the shareholders (pretty much in that order).

All of this was conducted in the glare of the public eye as the tech blogs and tech focused media was quite interested in how this story would play out. Kara Swisher called it "a very long and decidedly strange funding journey" in a blog post yesterday. She also said "the wrapping-up of what has been a very convoluted funding process comes after a series of missteps and switchbacks over what’s next for Foursquare."

I have great respect for Kara, who is one of the best journalists working in the tech sector, but I think she and many others who have voiced these sorts of criticisms are wrong.

The Company started this process when they had sufficient funds in the bank to operate the business for six months. They were not in a hurry and there was no need for any kind of interim bridge financing as Kara's post suggests. So closing the financing quickly, which is often advised as the best approach, was not necessary and in hindsight, the founders were wise to take their time.

The conversations with potential acquirers were very beneficial to the founders and the company in many ways. It helped them to understand what the risks of going it alone were versus the risks of selling. And both have risks if you are thinking about the service, the users, the team, and the shareholders (in that order). And it allowed the founders to develop close working relationships with some of the most important Internet companies who can not only be acquirers but also distribution partners and monetization partners.

I am a big believer in making quick decisions on most things. But on some things a bit of deliberation is important. In this case, the founders walked away from what Ben Horowitz from Andreessen Horowitz calls "generations of your people being set financially." Ben is also quoted in that same TechCrunch post saying "It is a really cathartic and emotional decision to make." Those kinds of decisions are best left unforced by the founders and the people around them.

In the end, the Company got a great financing with a great group of investors, including our firm, and now has the resources to invest in scaling the service, the team, and building out the feature set to make checking in an even better experience than it is today. 

So the moral of this story, if you will, is don't let conventional wisdom force you into making decisions you don't need to make and you aren't ready to make, particularly about very big decisions that you will be living with the rest of your life.

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I was talking to a friend over the weekend and he told me a story about a person he knows who made hundreds of millions of dollars of net worth in his career and then lost it all. I asked my friend how that could happen. He said "he made a lot of risky bets and none of them worked out."

I don't get how anyone could do that to be honest. I don't understand how someone gives Madoff all of their money to manage for them. When someone has very little to lose, I totally get betting it all and going for it. But when you have accumulated a nest egg or more, you must be diversified in your investments and assets. You cannot put all of your eggs in one basket.

Last week on MBA Mondays, we talked about Risk and Return. I made the point that risk and return are correlated. If you want to make higher returns, you must take on higher risk. But you can mitigate that risk by diversification. And this post is about that strategy.

One of the things most everyone learns in business school is portfolio theory (that's a wikipedia link if you want to learn more). Portfolio theory says that you can maximize return and minimize risk by building a portfolio of assets whose returns are not correlated with each other.

Let's use some real life examples. Let's say you have a portfolio of stocks and all of them are tech companies. To some degree, they are all correlated. When the tech bubble blew up in March of 2000, every tech stock went down. So if you had that portfolio, your portfolio went down big. Let's say you have a portfolio that has some tech stocks, some oil stocks, some packaged goods stocks, some real estate, some bonds, and some cash in it. When the tech bubble bursts, you get hit, but your portfolio does not "blow up." That is the power of diversification at work.

I have my own tech bubble story that is similar to that example. When the Gotham Gal and I moved back to NYC in the late 90s, we bought a large piece of real estate in lower manhattan from NYU. We sold a big slug of Yahoo stock that we got in the sale of Geocities to fund the purchase. And then we sold another big slug of Yahoo stock to fund a complete renovation of that real estate. Beyond those two sales, we did not get liquid on most of our internet and tech stocks because our funds were locked up on almost everything else.

When the bubble burst, our net worth dropped 80% to 90%. But it could have dropped 100%. That real estate did not drop in price. It actually increased by 2.5x over the eight years we owned it. That is the power of diversification at work.

Of course, we learned our lesson from that experience. We now have a fairly diversified portfolio of assets that includes venture capital investments, real estate investments, hedge funds, and municipal bonds. I am not suggesting that our mix is a good mix. I suspect we could be much more conservative and more "efficient" with our asset allocation if we hired a professional financial planner to do this work for us.

But this post is not really about our portfolio construction or even about asset allocation. It is about the power of diversification as a risk mitigator. 

Let's talk about diversification in venture capital funds. Making "one off" early stage venture capital investments is a bad idea. The chance that you will pick a winner in early stage venture capital is about one in three. I've said many times on this blog that one third of our investments will not work out at all, one third will work but will not be interesting investments. And all of our returns will come from the one third that actually work out. If you are making "one off" early stage investments and make five or six investments over the course of a few years, you do not have enough diversification. You could easily pick five or six investments and not once get to the one third that work.

We put 21 investments into our 2004 fund and I believe we will put between 20 and 25 investments into our 2008 fund. With that number of investments, we have a good chance of finding one investment that will be good enough to return the entire fund. And we have a good chance of finding another four or five investments that will return the fund again. We can handle a complete wipe out on between five and ten investments and still produce excellent returns. That is how diversification helps to manage risk in an early stage venture portfolio.

So if you are building a portfolio of anything, be it financial assets or anything, make sure to fill it with things that are not too similar and not too correlated with each other. To do otherwise is not prudent.

One of the most fundamental concepts in finance is that risk and return are correlated. We touched on this a tiny bit in one of the early MBA Mondays posts. But I'd like to dig a bit deeper on this concept today.

Here's a chart I found on the Internet (where else?) that shows a bunch of portfolios of financial assets plotted on chart.

 

As you can see portfolio 4 has the lowest risk and the lowest return. Portfolio 10 has the highest risk and the highest return. While you can't draw a straight line between all of them, meaning that risk and return aren't always perfectly correlated, you can see that there is a direct relationship between risk and return.

This makes sense if you think about it. We don't expect to make much interest on bank deposits that are guaranteed by the federal government (although maybe we should). But we do expect to make a big return on an investment in a startup company.

There is a formula well known to finance students called the Capital Asset Pricing Model which describes the relationship between risk and return. This model says that:

Expected Return On An Asset = Risk Free Rate + Beta (Expect Market Return – Risk Free Rate)

I don't want to dig too deeply into this model, click on the link on the model above to go to WIkipedia for a deeper dive. But I do want to talk a bit about the formula to extract the notion of risk and return.

The formula says your expected return on an asset (bank account, bond, stock, venture deal, real estate deal) is equal to the risk free rate (treasury bills or an insured bank account) plus a coefficient (called Beta) times the "market premium." Basically the formula says the more risk you take (Beta) the more return you will get.

You may have heard this term Beta in popular speak. "That's a high beta stock" is a common refrain. It means that it is a risky asset. Beta (another Wikipedia link) is a quantitative measure of risk. It's formula is:

Covariance (asset, portfolio)/Variance (portfolio)

I've probably lost most everyone who isn't a math/stats geek by now. In an attempt to get you all back, Beta is a measure of volatility. The more an asset's returns move around in ways that are driven by the underlying market (the covariance), the higher the Beta and the risk will be.

So, when you think about returns, think about them in the context of risk. You can get to higher returns by taking on higher risk. And to some degree we should. It doesn't make sense for a young person to put all of their savings in a bank account unless they will need them soon. Because they can make a greater return by putting them into something where there is more risk. But we must also understand that risk means risk of loss, either partial or in some cases total loss.

Markets get out of whack sometimes. The tech stock market got out of whack in the late 90s. The subprime mortgage market got out of whack in the middle of the last decade. When you invest in those kinds of markets, you are taking on a lot of risk. Markets that go up will at some point come down. So if you go out on the risk/reward curve in search of higher returns, understand that you are taking on more risk. That means risk of loss.

Next week we will talk about diversification. One of my favorite risk mitigation strategies.

The House has passed a bill this past week that would change the taxation of carried interest from capital gains treatment to ordinary income treatment. The Senate has not weighed in on the debate but it is expected to do so soon. The New York Times has a story about it in today's business section. I've written about this issue in the past, roughly three years ago when it first surfaced as an issue. I am in favor of taxing carried interest as ordinary income and I'd like to explain why I think it is good policy.

I agree with Victor Fleischer's basic premise that carried interest is a fee for managing other people's money. It is a fee based on performance, but it is a fee nonetheless. It is not fair or equitable to other recipients of fee income to give a special tax break to certain kinds of fees and not to others. 

But even beyond the basic argument of equity and fairness, there are some other important factors to consider.

We have witnessed financial services (think asset management, hedge funds, buyout funds, private equity, and venture capital) grow as a percentage of GNP for the past thirty years. The best and brightest don't go into engineering, science, manufacturing, general management, or entrepreneurship, they go to wall street where they will get paid more. And on top of that, we have been giving these jobs a tax break. That seems like bad policy. If we force hedge funds and the like to compete for talent on a more level playing field, then maybe we'll see our best and brightest minds go to more productive activities than moving money around and taking a cut of the action.

Changing the taxation of the managers will not reduce the amount of capital going to productive areas. The sources of the capital; wealthy families, endowments, pension funds, and the like, will still put the capital in the places where they will get the highest after tax return. And these sources of capital, if they are tax payers, will still get capital gains treatment on their investments in hedge funds, buyouts, and venture capital. And the fund managers will still have to compete with each other to get access to that capital and their incentives will still be to produce the highest returns they can produce, regardless of whether they are paying capital gains or ordinary income on their fees.

We may see the best managers investing more of their own capital and less of other people's money with these changes to the tax law. When I invest my own capital in a company (either directly or through my funds) and that investment generates a capital gain, I will still get to pay a lower tax rate. So at the margin, I might prefer to invest my own capital over someone else's with the new tax rules. I believe that is good policy. I have seen a correlation between a manager having significant "skin in the game" and long term performance. So if these tax changes produce more "skin in the game" that will be a good thing.

Finally, we need to balance the federal budget and we need both revenue increases and expense reductions to do that. Think about the hedge fund manager who is investing a $10bn fund. Let's say that manager produces an annual return of 8%. That's not an amazing year, but the manager will make $160mm in carried interest anyway. Under current law, the manager will only pay roughly 25% of that as taxes between federal, state, and local taxes. Under the new law, the manager will pay double that. That's a difference of $40mm for one fund manager. And there are a lot of fund managers out there. 

It's time for asset managers to start paying their fair share of taxes. We are among the most highly compensated people in the world. And we've been getting a huge tax break for years. It's not right and I am happy to see our government finally do something about it.

One of the issues with a trail of 5,000 blog posts going back over seven years is that sometimes you change your mind on something you wrote a long time ago but the words are still out there. That's the case with the issue of the participating preferred.

Yesterday, I came upon this tweet by Vijaya Sagar Vinnakota:

 

So I clicked thru to the first link and found a post I had written about participating preferred in 2004. In that post I stated "I insist on participating preferreds and get them in almost all of my deals."

Now some of you are wondering what a participating preferred is. I'll give you a brief explanation and then send you off to Brad Feld's blog for a complete description.

In a preferred stock, the investor gets the option of taking their money back in a sale or taking the share of the company they bought. I believe a preferred stock is critical in venture investing. However a participating preferred goes one step further. In a participating preferred, the investor gets their money back and then gets their ownership share of what is left.

Let's do a simple example. Let's say you invest $1mm for 10% of the business. And let's say the business is sold for $25mm. In a preferred (sometimes called a "straight preferred") you get the choice of getting your $1mm back or 10% of $25mm. You'll take the $2.5mm. 

But if you own a participating preferred, you get your $1mm back and then you split the $24mm that is left with the founder. So you get $2.4mm of what is left and the founder gets $21.6mm. You end up getting $3.4mm with the participating preferred vs $2.5mm in the straight preferred.

I grew up in the venture capital business in a firm that had the participating feature in its standard term sheet. I believed it was fair, particularly when there was a cap on "double dip" and that is what I believed in 2004 and wrote in the post I linked to above.

My views on this issue have evolved since then. The participating preferred is not in our standard early stage term sheet. It is not in any of our seed investments. We don't have it in "all of our deals." 

However, we do still use the participating preferred in two circumstances. First, it is a great way to bridge a valuation gap with an entrepreneur. Let's say we feel the business is worth $10mm but the entrepreneur feels it is worth $20mm. We could bridge that valuation gap by agreeing to pay $20mm with a participating preferred. If the Company is a big winner, then it won't matter if we paid $10mm or $20mm. But if the Company is sold for a smaller number, say $50mm, then having the participating feature gives us a return that is closer to what it would have been at our target valuation of $10mm.

The other place a participating feature is useful is when the entrepreneur might want to sell the company relatively soon after your investment. In that case, there is a risk that not much value will be created between your investment and an exit. A participating preferred works well in that situation as well.

In both cases where we still use the participating preferred, we cap it at a multiple of our investment, usually 3x. I mentioned that in my post back in 2004 and I have always believed that a participating preferred needs to come with a cap.

So that's my evolved view of this provision. I believe the venture business has changed as the capital required to create significant value in web services companies has fallen dramatically. That capital efficiency brings new economics to venture investing and terms need to evolve to reflect that. 

There is a big banking reform bill working its way through the Senate right now. It is sponsored by Chris Dodd, Chairman of the Senate Banking Committee. It has a long name I can't remember, so I'll call it the Dodd Banking Bill.

What does a bill attempting to regulate the banking industry have to do with startups? Well unfortunately, it contains two provisions that are quite problematic and hurtful to entrepreneurs and startups. They are:

1) Changing the definition of a "qualified investor" in angel and venture deals. Not just anyone can invest in a startup company. You have to be a qualified investor. A qualified investor is currently defined as anyone with a net worth of over $1mm or net income of over $250k. Dodd's bill would increase that to $2.3mm and $450k respectively. And then index those numbers to inflation.

2) Eliminate the existing federal pre-emption over state regulation of "accredited offerings." Angel and venture financings could be regulated state by state creating a fairly burdensome set of rules  and regulations that each financing would need to be subject to. Currently there is a federal pre-emption that makes getting these kinds of deals done fairly easy.

I have no idea why either of these provisions ended up in a bill designed to regulate the banking industry. Entrepreneurs and startups don't use banks to finance them. They get their initial capital from angel investors and then VCs as they grow. This system works well, did not blow up in 2008, and is not in need of reform of the type Dodd wants to throw at us.

In fact, what we need is to eliminate all accredited investor requirements for small investments of up to $25k. Why does someone have to be a millionaire to invest in a friend's startup? I understand that we don't want someone mortgaging their home, or betting their entire life's savings on a startup. But for a small amount, like $25k, we should not be regulating angel investing.

My dad sent me an email the other day pointing out a news story about an incubator in Texas that was cranking out startups and creating jobs. He told me that he believes that the work entrepreneurs and the people who work with them (ie me) are doing is incredibly important to the health of our economy. He's right and we need to explain that to Chris Dodd and his friends in the Senate. If they are going to reform accredited investor regulations, they should liberalize them, not constrain them further.

I'll get on the phone and call my Senators and Representatives. Hopefully you'll do the same. This is nonsense.

UPDATE: Irene left these details in the comments which will be helpful when you contact your representatives:

The section numbers in question are Sec. 412 for accredited investors and Sec. 926 for federal pre-emption or Reg D.

Link to pdf of bill: http://bit.ly/duxjSr

Link to TechFlash article with more info on possible influences: http://bit.ly/96uuEx

UPDATE #2: Dan Primack of PE Hub has just posted that congress is listening to all the uproar over this. Maybe we'll get to keep things the way they are. But I am still going to make the case that we need an exclusion for small investments made by non-qualified investors.

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Charlie O'Donnell asked me last week about lessons I learned on my first venture capital investment. I'm not entirely sure what my first investment was but I know what my first board seat was. It was a company called Upgrade Corporation of America (UCA), founded by Jordan Levy and Ron Schreiber and located in Buffalo, NY.

 UCA was in the business of providing outsourced sales, fulfillment and tech support services to the desktop software business. Ron and Jordy had previously built the largest software distribution business and had sold it to Ingram. They saw their former customers like Lotus and Microsoft starting to offer upgrades to new versions of their software programs directly via telesales. And since those upgrade campaigns happened once a year, it was ideal to outsource the upgrade sales and fulfillment to a third party. That third party was UCA. It became a large business and was eventually sold to SOFTBANK Corporation of Japan. It was a very good investment.

I was in my early 30s at the time and the classic "wet behind the ears" VC. Ron and Jordy were concerned that I was going to give them all kinds of worthless advice because I didn't really understand the business like they did. I told this story a long time ago on this blog, so I'll just cut and paste the rest of it from the original post.

I went to the first board meeting. It was in Buffalo, NY and the two entrepreneurs were Ron Schreiber and Jordan Levy, both of whom have become good friends and great VCs.

After the meeting, Jordan took me aside and said "Freddy (he still calls me that), if you want us to listen to anything you say in these meetings, you are going to have to spend some serious time getting to know our business".

I guess Jordan and Ron didn't like the idea of some wet behind the ear VC trying to tell them how to run their business.

I quickly recognized that I had to earn the right to tell them what I thought they should do.

So a couple weeks later, I cleared my calendar for 2-3 days and flew to Buffalo.

Jordan had arranged for me to spend time in every part of the business, from help desk to finance to sales and everything else.

I rolled up my sleeves and got my hands dirty.

I met almost every employee and learned what each job entailed. I even did some of the jobs.

By the end of my stay in Buffalo that week, I had a much better idea of what the business was all about.

And it made me a much better Board member.

I have Jordan Levy to thank for that lesson. He forced me to really understand the business. And I've taken that lesson to heart in my career. I don't like to invest in businesses unless I really understand them. And when I invest in a business that I do understand, I like to "roll up my sleeves and get my hands dirty." I like to engage with the management team and help them build the business.

There is a fine line between "getting your hands dirty" and meddling. You have to let the entrepreneurs and management team operate the business and make all the key decisions. But that doesn't mean you can't help them. And to help them you need to understand the business. So roll up your sleeves and get your hands dirty and you'll be a better investor.

The 2009 data on venture capital investments is out now. PWC, along with its partners the NVCA and Thomson Reuters, report that VCs invested $17.7bn in 2009 in the "Money Tree Report."

I think that's a pretty healthy number. I've written in the past that $15bn per year is a good number given the "Venture Capital Math Problem."

My concern is that investing went up in the second half of the year to a $5bn/quarter rate, which is $20bn run rate, a bit above the number that I think is optimal for the industry's returns.

2010 will be an interesting year. If VC investments go back up to $25bn to $30bn per year, then the diet didn't stick and we are back to an overfunded industry that will produce subpar returns on average.

If, on the other hand, the new normal is $15bn to $20bn per year, then the diet worked and we've scaled back the business to healthy levels.

Stay tuned and find out which one it is.

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