Posts from Investor

Herky Jerky Investing

The WSJ says some venture funds hit pause on big deals. The Journal describes

a group of venture capitalists dialing back on certain deals after a breathless year of venture investing that had some comparing 2011 to the late 1990s dot-com bubble. Many venture capitalists said they now are increasingly passing on companies seeking frothy valuations, and some are trying to get off the beaten path to find cheaper deals.

I am not a fan of this start and stop style of investing. Nobody can time markets. You can't deliver great returns to your investors by being a momentum investor during some periods and a value investor in others.

I believe the only way to be a top performing investor in any asset class is to have a disciplined investment strategy and approach and apply it consistently and actively in all markets all the time.

I am proud that our firm has been investing at about the same rate of new investments per year for almost eight years now. It hasn't gone up much but it also has not gone down much. We will never be the most active venture capital firm. But we will never be inactive either. We are open for business as much today as any other day in the past eight years. If you are building a large network of engaged users that has the potential to disrupt a big market, please talk to us about what you are doing.

#VC & Technology

MBA Mondays: Cap Tables

Cap Tables (short for capitalization tables) are spreadsheets that show how much everyone owns of the company. You can get a stockholder ledger from your lawyer that will list all the stockholders and show how many shares or options they have, but I don't consider that a cap table.

For the past 25 years, I've used a simple form, mostly given to me by the partners I worked for when I first entered the venture capital business in the mid-80s, but with a few modifications by me over the years. It looks like this (click on the image to enlarge):

Cap table

Last night I put together a public read-only google spreadsheet that shows you a basic cap table in the format I like to use. You can check it out here.

The basic outlines of this cap table are:

1) it shows all the major stockholders of the company listed down the left side. it also shows the major option holders and buckets of option holders

2) it shows all of the classes of stock and how much was paid for them across the top of the columns

3) for each investor, you show how much of each class was bought and how many shares of that class they own as a result

4) you total up the cost and shares and then calculate ownerships on a fully-diluted basis (which means you include the options, whether issued or non-issued or vested or non-vested).

I like this presentation for its simplicity and because it shows the progression of financing activity. It also has the benefit of showing how much each investor has put in on a cost basis, which many cap tables leave out.

If you want to make a cap table for your company, feel free to replicate this format. If you have angel investors, put them in the angel section. I would include the largest ones and bucket all the rest into "other angels."

If you've got any questions about this cap table, or cap tables in general, feel free to ask them in the comments. I will answer them (maybe not until late today or tomorrow -I've got a crazy day today). And I bet the community will answer them too (probably well before me).

#MBA Mondays

How Much Money To Raise

A Stack of BillsImage via Wikipedia

I spent some time yesterday talking to an entrepreneur about this topic and I thought I'd share what I told him with everyone.

When your company is growing really fast, doubling employees year over year, adding users and customers at a very rapid rate, you don't want to raise too much money. If you raise three or four years of cash, there is a very good chance that by your second year, you will be sitting on cash that you raised when your company was worth considerably less. That's not a good thing. It's too dilutive to you and your co-founders and angels.

I've got two basic rules of thumb. First, try to dilute in the 10-20% band whenever you raise money. If you can keep it to 10%, that is great. You might have to do more, but try hard to keep your dilution below 20% each round. If you do two or three rounds at north of 20% each round, you'll end up with too little of the company.

Second, raise 12-18 months of cash each time you raise money. Less than a year is too little. You'll be raising money again before you know it. Longer than 18 months means you may well be sitting on cash that you raised when your company was worth a lot less.

These rules are most applicable in the early stages. When your company gets above 100 employees and valued at north of $50mm, things change. You may need to have more cash on your balance sheet for working capital reasons and you may not be increasing value at quite the same rate as you were when you were smaller. You might want to raise 24 months of cash or more at that stage.

But for the seed, Series A, and Series B rounds, I think 10-20% dilution and 12-18 months of cash are ideal. It's what I advise our portfolio companies to do and it is what I advise other entrepreneurs to do.

#VC & Technology

Financing Options: Friends and Family

This is the first in a series of posts about financing options for startups. By "financing" I mean obtaining cash to fund your business. There are all sorts of strategies to avoid needing funding, but this series is not about them.

Many entrepreneurs turn to friends and family for their first funding needs. In fact, it is common for non-tech startups to raise all the capital they need from friends and family. I don't know for sure, but I would suspect that friends and family make up the largest source of funding for entrepreneurs and startups.

Friends and family financing is popular because it is easy to get a hearing from the people who know you best and they are positively inclined to say yes. But there are some negatives as well. It's tough to know how to price and structure an investment where the investors are close friends or family. You don't want to take advantage of them and they may not be sophisticated enough to know what is a good deal and what is a bad deal.

And friends and family often cannot come up with a lot of capital so unless your business doesn't need much funding, this will not be the only round you do. But friends and family can get you into business and give you some time to create value that other investors will recognize and value.

Probably the most tricky part of friends and family financing is that you really don't want to lose money that friends and family have invested with you. And most startups fail so the chances that will happen are high. I would encourage entrepreneurs who take funding from friends and family to be very clear about the risks and downside. I would also suggest only taking capital from friends and family members who can afford to lose the investment. That way, if the investment does turn out to be bad, at least you won't lose valuable relationships. Even so, it is easier on the mind to be doing a startup when your capital comes from professional investors than your loved ones.

I would recommend doing friends and family financings as convertible notes with a discount and a cap on the valuation. That way you don't have to worry about how to price the investment. A 20-25% discount from the next round is appropriate. The valuation cap is going to vary depending on the size of the raise and the size of the opportunity. I'd suggest a cap that gives the friends and family around 10% of the business if things work out. But that is just a suggestion. A 10% interest will not be appropriate for every friends and family investment.

Friends and family funding is the most common form of startup financing but also the most tricky in many ways. Be careful to do it right because there's a reason why these people will back you when nobody else will.

#MBA Mondays

Some Thoughts On InvestorRank

Chris Farmer, a VC with General Catalyst, presented some interesting data yesterday at Disrupt. He ranked VC firms on the basis of what companies they invested in as the first VC investor. If you invested in a highly successful company in the first round, you get "InvestorRank" and like Google Page Rank, that rank is transferable to other firms. If you follow an investor in the next round, some of your rank will transfer to the firm who led the deal before you.

This is an insightful way to look at the early stage venture capital business. The objective of early stage VC investors is to get into the best deals in the first round and then to get other high quality firms to follow on in the next rounds. That is how it was taught to me and it is how we have built the two firms I have co-founded.

I haven't studied Chris' data to have a point of view on the ranks he has calculated and the ratings he presented. But if I was investing in venture capital firms as an LP, this would be a big part of what I would look at.

Returns are important, but they are a trailing indicator. There is no guaranty that past returns will be an indicator of future returns. What is more important is the team, the strategy, and their ability to get into the right deals and build the right syndicates. InvestorRank is a good attempt to quantify that last bit.

#VC & Technology

Sizing Option Pools In Connection With Financings

We've talked about this issue before here at AVC. Investors like to require that an unissued option pool is in the pre-money valuation calculation when they put money into early stage companies. If you don't entirely understand what I am talking about here, go click on that link at the start of the post. Hopefully it will explain the issue.

This post is about how to size the option pool. Many investors just want the number to be as big as possible. They'll put 15% into the term sheet and then let the entrepreneur negotiate them down from there and maybe if you are lucky you'll get them to 10%. But there is no logic in that kind of negotiation. It is just a price negotiation disguised as something else. It is bullshit. And I see investors engage in that kind of practice all the time. It annoys me.

What I like to do, as I mentioned in the post I linked to, is agree with the entrepreneur that the option pool will have enough unissued options to fund all the hiring and retention grants that need to happen between the current financing and the next one. Then we'll do the same thing at the time of the next financing. That makes sense to me. And it is pretty easy to do.

Let's say you are raising $1mm at $4mm pre-money. And the investors want the option pool to be in the pre-money valuation. Let's say the $1mm will last you 18 months. Then you determine how many people you are going to hire in the next 18 months. If the financing is $1mm, it's not going to be that many. You probably have three to five employees already. Without revenue coming in, five employees will suck up half of that money over 12 to 18 months. So at most you are going to hire another 5 employees.

Here's a formula I like to use. Take the cumulative salaries of all the hires you need to make betwen the current financing and the next one. Let's say it is five employees at an average of $75,000. Then that number is $375,000. Then divide that number by the post-money valuation, in this case $5mm. That gives you 7.5%. That's the size of the option pool you'll need. And it is conservative because I don't recommend giving options equal to the dollar value of the annual salary of your hires. I like anywhere between 0.1x to 1x (depending on role and responsibility), with the average being in the .25x range. But early on in a company, you will need to and want to be more generous.

This approach assumes you have already granted employye equity to the existing team. Ideally they will have founders stock or restricted stock. But whatever they have, they should be holding sufficient equity to keep them happy and excited to be working in your startup. If that isn't true, you will need to add some additional equity to the pool to take care of them.

The bottom line is that sizing up option pools should not be like horse trading. It should be a science. It should be based on an option grant methodology that is driven off annual salary, and an option budget based on headcount and hiring plans. And if you do it that way, you will end up with a lot less dilution. Which is what you should always be trying to achieve.



#MBA Mondays#VC & Technology

The Word Bubble

In all the posts over the past year or so outlining my thoughts on the financing and valuation environment in the internet sector, I've avoided using the word Bubble. It is intentional. For me Bubble will always be inexorably linked to what went down in 1999 and 2000 in the internet sector. And I agree with Mike Arrington that what is going on now is different. I do not think we are in a Bubble per se. That is why I don't use the word.

But I am equally sure that we are in the glass is half full part of the cycle. Investors are focusing on the upside and ignoring the downside. That part of the investment cycle lasts for a while and then things change and investors focus on the downside and ignore the upside. Markets are defined by greed and fear. We are in the greed mode right now.

I don't view this as whining. There is nothing to whine about. Investors are making money hand over fist. Why would I whine about that? But I do think it is important to point out the inevitability of the market cycles. There will come a time when the environment we are in will be in the rear view mirror. And entrepreneurs should be crystal clear about that. This is a time to raise money and sock it away for a rainy day. Because it will rain.

And investors should recognize that the current valuation environment will not exist at some point in the future. The companies we invest in will need to grow into these valuations or we will face writedowns and writeoffs. We should not let the greed emotions cloud our judgement. Yes, that hot deal sure looks damn good right now. But deals are actually companies and most venture investments are held for five to seven years. I've likened them to marriages over the years. Don't let the lust for the deal lead to a bad marriage that you have to be in for the next decade.

I've made all of these mistakes. I know what happens. I am prepared for it. That doesn't mean we aren't investing in this cycle. We are as active as we've ever been. But we are investing at this stage of the cycle with our eyes wide open. And I'm writing about it in the hopes that others do the same.



#VC & Technology

When They Are Throwing Money At You

Companies get hot. And investors start throwing money at them. Entrepreneurs get calls and emails all day long from investors wanting to invest. After a while, the entrepreneurs start to think that they should take the money. Not because they need it, but because they figure if people are throwing money at them, it's probably a good idea to take some.

Given that we are in the "throwing money at entrepreneurs" period in web investing, I thought I'd say a few things about this.

1) Don't take money you will never ever need. No matter what price and terms the money is offered, it has a cost. Money is never free. If you have absolutely no need for the money then don't take it.

2) Money lying around tends to get spent. It is a very hard mental exercise to sock away a bunch of money and forget about it. If you think you'll just raise the money and put it away for a rainy day, just know that will be hard to do. And if you have team members who have ideas about how to spend/invest it, it will be even harder.

3) If you need the money, then raise it now. I have not seen a better time to raise money for web startups since the late 90s.

4) If you don't need the money, but have some ideas about how you could put it to good use, then do some hard work on those use cases. Flesh them out. Size them up. Build a plan. Then raise the money and execute the plan.

5) If your company doesn't need the money, but you sure could use some, then think about selling some secondary shares. But don't sell a lot. Maybe 10-20% of your position. I've come to believe that entrepreneurs putting away some money to protect the downside is largely a good thing. It allows them to take bigger risks and play for more upside.

6) Do not let the fact that your competitors are raising money impact your decisions around fundraising. I have not seen one company beat another because they raised more money. Most of the time it is the other way around. The overfunded company loses most of the time.

7) Don't let this environment make you crazy. I understand the problem. We get calls and emails too. It is tempting to get caught up in the nutty market we are in. Focus on your business, your product, your team. Put all this stuff in perspective and don't let it take you mind off what matters. You need money to build a business but the money is a tool, the business is the mission. Focus on the mission.

The financial markets will come and go. Sometimes investors are focused on the downside. Other times they are focused on the upside. Right now it is the latter. But someday it will move to the former. That's how financial markets behave. End markets, the place all businesses get paid day in and out, don't whipsaw you like financial markets. Build a product and sell it to the end market and get profitable and create lasting sustainable value and you'll get to the pay window on your terms and your time frame.



#VC & Technology

Doubling Down On The Overpay

One thing I've seen many VCs do wiith their initial investment in a company is invest more when the valuation gets expensive. They are ownership driven, not valuation driven. So if they originally wanted to invest $4mm at a $20mm post money valuation and buy 20% of the company, they talk themselves into investing $8mm at a $40mm post money valuation so they can still buy 20% of the company.

I have never liked this approach. When the price of an initial investment goes up, I prefer to invest less, or nothing at all. Investing nothing at all is a fairly obvious approach when the price gets beyond your comfort zone. Investing less is not as obvious.

My rationale for investing less has to do with the fact that most venture investments involve multiple rounds. If you believe there will be additional opportunities to invest in the company and you really want to be involved, then you can invest less and reserve more funds to invest later in hopes that the risk reward of the investment improves. Since you will be an investor in the company, you will be shown those opportunities before or at least alongside new investors in future rounds.

Investing more when the price is too high makes no sense to me. If you are overpaying by 2x, doubling down feels like overpaying by 4x.

I think the root of this "doubling down on the overpay" issue is that many VCs manage large funds of other people's money and they really don't care so much about how much they invest in each deal. They are looking to buy large stakes in companies and hope that one or more turns into a big winner.

I try to invest as if I have a fixed amount of capital and it is my own capital (some of it is). I like to think that every investment we make takes funds away from other investments we can make, even though this is not actually true. Our firm could raise more money if we wanted it and needed it. But I think raising larger funds will ultimately lower the returns we can deliver to our investors and we have resisted doing that.

So instead of being ownership focused, I prefer to be valuation focused. And the key figure I look at is average valuation of our entire investment. We take the total amount of capital we have invested in a company and divide it by our total ownership. We like that number to be as low as possible relative to the current value of the business. I believe that is the recipe for the best returns and that is what we seek to deliver to our investors.



#VC & Technology