Posts from Venture capital

In the comments to last week's Burn Rate post, I was asked to share some burn rates from our portfolio. I can't do that. But an alternative suggestion was to write a post suggesting some reasonable burn rates at different stages. I can do that and so that's the topic of today's post.

The following applies to software based businesses, and most particularly web and mobile software businesses. It does not apply to hardware, life sciences, and energy startups. It is also focused on startups in the US. It costs less to employ teams in many other parts of the world.

Building Product Stage – I would strongly recommend keeping the monthly burn below $50k per month at this stage. Most MVPs can be built by a team of three or four engineers, a product manager, and a designer. That's about $50k/month when you add in rent and other costs. I've seen teams take that number a bit higher, like to $75k/month. But once you get into that range, you are starting to burn cash faster than you should in this stage.

Building Usage Stage – I would recommend keeping the monthly burn below $100k per month at this stage. This is the stage after release, when you are focused in iterating the product, scaling the system for more users, and marketing the product to new users. This can be done by the same team that built the product with a few more engineers, a community manager, and maybe a few more dollars for this and that.

Building The Business Stage – This is when you've determined that your product market fit has been obtained and you now want to build a business around the product or service. You start to hire a management team, a revenue focused team, and some finance people. This is the time when you are investing in the team that will help you bring in revenues and eventually profits. I would recommend keeping the burn below $250k per month at this stage.

A good rule of thumb is multiply the number of people on the team by $10k to get the monthly burn. That is not the number you pay an employee. That is the "fully burdended" cost of a person including rent and other related costs. So if you use that mutiplier, my suggested team sizes are 5, 10, and 25 respectively for the three development stages listed above.

Once you get the business profitable, you can scale the team larger and larger to meet the needs of the business. I don't think of that kind of expense as "burn rate", I think of it as "scaling the team." I believe you want to use a bottoms up budgeting process to determine your headcount needs at this stage of the business.

One final caveat – there are outliers. Twitter had a higher burn rate than I am recommending during the second stage due to the massive scaling costs they encountered. And Facebook had a higher burn rate during the building the business stage due to the size of the revenue team that they assembled and other needs of the business. There are some business opportunities that are large enough that they can justify (and fund) larger burn rates. The mistake we all make is assuming that many of our companies are outliers. There are very few companies that can justify a million dollar/month burn rate or larger. There are many more that thought they could and are no longer around.

Steve Blank has a great post up on his blog suggesting that VCs should require startup CEO experience in their partners' resumes. He quotes from me in that post but I'm not going to state which one came from me. You can guess if you want.

You might be surprised to know that I agree with Steve. I have never run a startup company. By Steve's measure, that is a weakness in my background and experience. And I agree that it is. I've managed to overcome that weakness, but it is a weakness nevertheless.

I particularly like this paragraph in Steve's post:

What running a company would do is give early-stage VC’s a benchmark for reality, something most newly-minted partners sorely lack. They would learn how a founding CEO turns their money into a company which becomes a learning, execution and delivery engine. They would learn that a CEO does it through the people – the day-to-day of who is going to do what, how you hold people accountable, how teams communicate, and more importantly, who you hire, how you motivate and get people to accomplish the seemingly impossible. Further, they’d experience first hand how, in a startup, the devil is in the details of execution and deliverables.

Newly-minted partners are a big problem for entrepreneurs (and VCs too). And Steve's suggestion that they get a dose of reality before opining on stuff in board rooms is great. If a super talented young person in our firm shows an interest in a partner track, I would strongly consider Steve's approach.

John Doerr famously said that it takes $30mm of losses to train a VC. I am proof of that theory. But as Steve points out, you can start a company and operate it for a year for less than $500k these days. That sure sounds like a less expensive way to learn how to be a VC.

Back when we were doing our MBA Monday series on Financing Options For Startups, I got an email from my friend Andy Sack. Andy was one of the first entrepreneurs we funded by in the mid 90s with our Flatiron Fund. He's done something like a half dozen startups since then and he's a veteran in the very best sense of the word.

Andy said "You missed an important option Fred – revenue based financing. I've got a new firm called Lighter Capital that does just that". I said, "Can you write a blog post for MBA Mondays explaining how it works?" So today, we have a guest post/advertorial on Revenue Based Financing from Andy/Lighter Capital. I hope you like it.

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Fred’s series on alternative financing options has been awesome to follow, especially because it broadens the discussion of how companies can fund business growth when they can’t (or don’t want to) raise venture capital or bank debt. Fred’s original list missed one option – revenue-based finance – that's near to my heart and I’ve been encouraging entrepreneurs and angels to consider, and Fred graciously let me offer my insights here.
 
Disclaimer: I am founder of Lighter Capital and have a self interest in educating and promoting the use of this new type of financing called revenue-based finance.  I’m also a serial technology entrepreneur and believe this type of financing has real advantages to traditional debt and traditional real advantages over equity for the entrepreneur.

A revenue-based finance (RBF) investment provides capital to a business by “selling” an ongoing percentage of a company’s future revenues to the investor.  For simplicity, you can think of it as a revenue share type of arrangement. Investor gives capital to company in exchange for a small percentage of gross revenues. RBF lives as a hybrid of bank debt and venture capital. This kind of financing has been around for a while in non-tech industries such as mining, film production and drug development, but it’s recently been gaining traction in the world of growth finance and early-stage technology funding.
 
I want to explain how an RBF structure is different than traditional funding sources, detail what situations could be better suited for an RBF structure (for entrepreneur and investors alike), and offer a word of warning about the businesses that aren’t a good fit for the structure.
 
First, let me explain how a revenue-based loan works:

Instead of a typical bank loan which requires a business to pay a fixed interest payment, a revenue-based loan receives a percentage of revenues over a specified amount of time, allowing "interest" payments to fluctuate when a growing company has inconsistent cash-flows or lumpy or seasonal revenues. In a world where business costs such as software and infrastructure are increasingly becoming “as-a-service” and adjust with the ebbs and flows of a business needs, RBF payments automatically ramp up and down along with a business. It’s the inherent variability of RBF that makes the structure so appealing so appealing.  Imagine if your business loan payment reduced to zero if your business revenue dropped to zero for an unanticipated quarter, and then automatically kicked backed on when your revenue returned. Another way of saying this is RBF turns loan repayment from a fixed expense to a variable expense.

So, when does it make sense to raise revenue-based funding?
Revenue-based loans are, by nature, most appropriate for companies already generating revenues but without hard assets typically required to get bank loans. It’s especially applicable for companies that have lumpy, seasonal, or hard to predict revenues.

 
For entrepreneurs, revenue-based loans are attractive to founders who are allergic to dilution and loss of control.  The structure of RBF is often non-dilutive to founders and does not require a board seat. The financing is obtained without having to agree to a valuation, which leaves management in control of the company and typically requires no personal guarantees from management.

RBF means you can grow without swinging for the fences

For investors, funding using an RBF structure provides an opportunity to get a return on their investment without needing an exit. While this is clearly an advantage for investors, it also means company founders shouldn’t get as much pressure from investors to “swing for the fences” and the projected return due to the investor can be lower as the entrepreneur repays the investor more quickly.

As Fred has mentioned before, big exits are rare for startups. Some ideas have the potential to be home runs, but others are better suited to operate as smaller, standalone businesses. For the companies in the latter category, raising money from VCs who expect the big exits can misalign goals. A revenue-based loan has the potential to better align incentives for investors and founders in these cases. With that said, if you’re a pre-revenue, startup still figuring out your business model or considering some kind of “go big or go home” strategy, there can be realadvantages to working with the equity-based venture capital or angel investors. Similarly, certain businesses, especially brick-and-mortar and manufacturing-focused businesses may not have the margin profiles to pay monthly payments of 2-5% of revenues.
 
An RBF structure isn’t limited to specific funds – angels, VCs or banks could theoretically provide capital in this manner, but the risk/return profile of RBF doesn’t always fit the investor’s needs. Similarly, RBF may not be the best funding option for all businesses. In the right circumstances, the hybrid approach of revenue-based finance for startup funding can have advantages over traditional debt or equity, but there are admittedly situations where the more traditional options still make sense – such as restaurants or infrastructure-heavy startups.
 
If you’re considering raising money from angel investors, I’d suggest discussing this in the event that it may align your incentives better or at least help avoid some of the painful valuation negotiations. There are a few funds –Lighter Capital and Next Step in Texas, among others focused on this type of structure and I’d suggest taking a look at those options as well. There are clearly different scenarios where any number of Fred’s financing alternatives could prove more appropriate for your business, but the revenue-based loan structure can be a great option for profitable companies looking for a straightforward way to raise funding without dilution, change of control, or a personal guarantee.

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):

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).

I've been reading Eric's book which I am very much enjoying. And on wednesday night I spoke to the NYC Lean Startup Meetup with the help of Giff who interviewed me.

Eric and his fellow lean advocate Steve Blank have both written at length about the methodologies associated with the lean startup approach. If you have not read their books (Steve's here), I suggest you do.

But the most interesting part of the discussion on wednesday night for me was when Giff asked me about a comment I had made that "you need more than a lean methodology, you need a lean culture."

To me, lean is a state of mind that a founder and his/her team needs to have across all aspects of the business. The specific product and engineering approaches that are at the core of the lean startup movement are paramount for sure. But if you can apply lean to hiring, sales, marketing, customer service, finance, and everything else, you will be rewarded with a fast, nimble company. That's a winning model, especially when things are moving fast in many dimensions as they are right now.

Later on in our conversation on wednesday night, I got a question about lean and venture capital. To me, USV is a lean VC firm. Brad and I set it up that way because we talked about all the things we didn't like about venture capital firms when we were setting USV up in late 2003.

My prior experience at Flatiron was instructive. In the first two or three years of Flatiron, it was basically just me and Jerry. We were deeply engaged in all of our investments and we had one or two employees other than ourselves. We did very well in that period. In mid 1999, we went on a binge, raised a huge fund ($350mm), moved into a massive office, hired a staff of 25, made investments we weren't engaged in, and got fat. We did poorly in that period. We shuttered Flatiron in 2001 and I took over the entire portfolio with the help of Jerry and Bob. It was basically back to the early model. We did very well in that period.

I do not believe that venture capital scales. I believe you need a small team of highly engaged partners and not much else other than great relationships with entrepreneurs. We do have a small team of non-partners at USV. Dorsey runs the office. Christina runs the investment stuff. Gary runs the portfolio engagement stuff. That's it. It works really well. We've kept USV lean and I believe that has allowed us to focus on what matters most, to react quickly to opportunities, and to be focused externally as opposed to internally. And when I look at most of the VC firms I admire, I see similar lean approaches. It's a winning model.

The media has had a lot of fun over the past week watching AOL, Huffington Post, TechCrunch, and Mike Arrington figure out how to move on. I feel badly for the TechCrunch crew including MG, Erick, Sarah, and many others. They are awesome at what they do and I feel that they've been left dangling as this soap opera has played out.

I do not feel badly for Mike. He's a bigtime player in silicon valley and he will be fine. Contrary to what many in the media say, he does not need TechCrunch as a platform to be influential. He is influential becuase of who he is, not where he writes. His reputation is made and as long as he finds his next platform, be it a venture fund, a blog, or both (how can anyone have both a blog and a venture fund????), he will remain a hugely influential force in silicon valley and tech.

But TechCrunch is a big question mark. If AOL can keep the rest of the team together, then TechCrunch has a bright future. No company is so reliant on one person that they can't survive that person's departure. But if others move on, including the people I mentioned above, then TechCrunch could lose its swag, as my son would put it. Yes TechCrunch gets scoops. That happens because it has a huge audience of the right readers and people in tech choose to leak to TechCrunch to reach that audience. But TechCrunch also has a voice, a swagger, a "fuck you" attitude that comes from Mike. That can also live on without Mike if AOL allows it. They need to keep the remaining team, the voice, and that attitude if they want to remain at the top of the world of tech media.

There's also a super awesome asset inside TechCrunch that doesn't get much attention. It is Crunchbase. There have been many attempts to build premium databases for the venture capital and startup world. All of them suck. But Crunchbase, which is free, almost open, almost peer produced like Wikipedia, is fantastic. Whatever happens to TechCrunch AOL, please don't mess up Crunchbase. It is the premier data asset on the tech/startup world and an incredible example of how free beats paid in the online world we live in.

If AOL can't retain the TechCrunch team, can't maintain its voice and swagger, then TechCrunch will cease to be relevant and the audience will move on. Most likely to a new media property which most likely will be started by some number of ex TechCrunch employees. That's how it goes in media these days. Big companies don't control media assets as strongly as they used to. It doesn't cost much to publish news these days once you know what the news is. See Dan Frommer's Splatf for a great example of what can be done by one person working part time.

So I'm hoping that TechCrunch remains vital and the remaining team stays on. But I'm not terribly worried about it. The TechCrunch audience, including me, will find new sources of news, information, and entertainment elsewhere if that's what needs to happen.

Yesterday was a fantastic day.

I started out with a breakfast with an entrepreneur who is going to launch the web and mobile app he and his team have been building in the coming weeks. The excitement on his face was infectious.

Then I went to the kickoff board meeting for a new investment our firm made. The company is growing fast, the service has serious traction. Growing pains and big plans vied for everyone's attention.

Then I went to another board meeting for a company that has been around for between four and five years. We provided the initial capital to get it started. The business has grown to the point that all systems are working well, it's a real company with real revenues and profits right around the corner. We talked about the next big strategic moves we are going to make.

Then at 6:30, after back to back board meetings, I went to meet with the fourth of our portfolio companies in a single day. We talked about how to step on the gas wtih a business that is ramping super fast and busting at the seams.

Four portfolio companies. Each at a different stage. Each in a different business. Each with a different team. All doing great things. It's this ability to engage meaningfully with many interesting teams and busineses in a single day that makes the venture capital business the perfect job for me. I love it.

A few weeks ago Jason Calacanis stopped by our new offices and recorded an episode of This Week In Startups. It was a fun chat, almost an hour long. My audio is not as good as the audio on Jason so it's a bit hard to hear me unless you want to hear Jason shouting.

If you want to fast forward through the sponsorship message, go to 6:30 and start there.

If you want to fast forward through parts of the discussion, here is the breakdown:

0:00-1:00 Welcome to TWiST from NYC in the Union Square Ventures' offices.
1:00-2:00 Thank you to iStockphoto for sponsoring the show.
2:00-6:30 Demonstration of how easy it is to purchase high-quality photos within iStockphoto.
6:30-8:00 Welcome to Fred Wilson, principal at Union Square Ventures.
8:00-8:30 Jason: The biggest mistake of my career was not listening to [Fred’s] wife when she advised me to go national with Silicon Alley Reporter.
8:30-9:30 How much of being a VC is being a therapist to the entrepreneurs?
9:30-10:30 You’ve worked with Mark Pincus, what was that like?
10:30-11:45 You invested in all four of Mark’s companies, yes?
11:45-14:00 When Mark came to you for the fourth time with Zynga, what did you say?
14:00-15:15 The same sort of situation happened with Twitter, didn’t it?
15:15-16:30 If a VC flies out to see you–the entrepreneur–you know there’s serious intent.
17:45-19:15 So speed is the big difference between web 1.0 and now?
19:15-20:15 Have you ever spoken for your companies too much on your blog?
20:15-20:45 Your blog has really made you into one of the most well-known east coast VCs around today.
20:45-22:30 How much of your success this time around has been because of the blog?
22:30-23:30 Did you enable too much transparency and lose some of your power?
23:30-24:30 If money’s not an issue, why go to a VC?
24:30-25:00 Are there funds that are now following Union Square Ventures?
25:00-26:00 Thank you to MailChimp for sponsoring the show.
26:00-29:30 Demonstration of how you can segment your lists to target your emails using MailChimp.
29:30-30:00 Fred explains why he would like to see entrepreneurs work backwards and think about who they would like to invest in them.
30:00-32:15 How do you reconcile this, the new golden era of Internet companies, with the scars you have from past fund failures?
32:15-33:00 When do founders start thinking, “I should start a new company?”
33:00-35:15 Let’s talk about entrepreneurs. What are you looking to see in the eyes of an entrepreneur?
35:15-37:00 So you’re looking for a persuasiveness that is so strong, people can’t help but follow that person?
37:00-38:15 Do you find that this new generation of founders has an entitlement issue, thinking that they’re owed success?
38:15-39:15 Does that make that person impossible to manage?
39:15-42:15 Are you on the secondary markets? What’s your take on that?
42:15-43:45 Fred: Are Mahalo shares being traded?
43:45-45:30 Are limited partners stoked about the secondary market?
45:30-46:15 Why does a venture firm put money into a single established company and not into several startups?
46:15-48:30 What does an opportunity fund mean?
48:30-49:00 Fred: In the private equity business, you buy one and you’re done. In the venture business, you make multiple investments and the risks are mitigated.
49:00-50:40 What’s your advice for a young entrepreneur who wants your money?
50:40-51:15 Fred, it’s been great to watch you rise over the years. Thank you so much.
51:15-51:45 Thank you again to our sponsors. We appreciate all of your support!

That's how Skype's option plan is described in this piece by Felix Salmon. I've seen option plans that have repurchase rights in them. They used to be more common twenty five years ago when I entered the venture capital business. The theory was that employees would have to stay until the exit if they wanted to keep their equity (be in it to win it). But in practice, once employees realized that was the deal, they were actually incented to leave because they didn't trust that the equity they were vesting would ever produce a payday for them. So they went elsewhere and created value for an employer with a better deal.

Today, the "market" deal in employee option plans is that employees have to exercise their options within some period after leaving (typically 90 days). This is a better deal for the employee than a repurchase right but can still create hardship for employees as it may cost real money to exercise and there are often tax issues with exercising options. This requirement to exercise upon departure is a big reason why the secondary market in employee common stock has taken off. Employees who leave companies need to sell some of their vested stock to come up with the cash to exercise and pay taxes associated with exercise.

This is a tricky area. Companies feel that employees who stay and work to create ongoing value should have a better deal on their vested options than employees who leave and go to work elsewhere. I understand that point of view. But it is also true that your employees need to feel that the options they are vesting are going to be worth something and that they will be able to keep them when they leave.

Companies also want to control their stock and keep it off of secondary markets where they can end up wtih shareholders who they don't know. The requirement to exercise within a short period of departure is in conflict with the desire to control the cap table.

I believe this whole area of "what happens with the options when the employee leaves" needs to be rethought in light of where we find ourselves right now in startupland. I'm not sure I have any particularly good ideas but I know that the way we do it right now is problematic for everyone.