Posts from Venture capital

I was reading Mark Suster's latest blog post (actually its a presentation embedded into a blog post) and I came across this slide.

I don't know what the source of this data is and I don't know if this is just M&A exits or if it includes IPOs as well. It really doesn't matter for the basic point that Mark is making with this slide.

Based on the NVCA statistics on the venture capital industry, there are on average 1,000 early stage financings every year. I suppose a few of those 1,000 financings are for the same company, but I doubt that many are. So we can use 1,000 as an approximation of the number of companies that get funded in a given year.

And somewhere around 50 and 100 of them exit for more than $100mm every year. So 5-10% of the companies financed by VCs end up exiting for more than $100mm.

At at time when the average Series A round is now north of $20mm (based on very anecdotal evidence and not at all scientific), this poses challenges for the VC industry.

The real math is a lot more complicated because of follow on rounds and such, but in order to keep this simple, let's assume all Series A deals are done at $20mm post-money and 5% of them end up exiting for north of $100mm. And let's assume that the average valuation of the exits north of $100mm is $250mm (I think that's a good guess but it could be off). That means you don't get your money back on your entire 20 investments with the one that has a good exit. The simple math is 20×20=400 which is greater than 250.

If the average valuation of a Series A deal is $10mm, then the cost of 20 early stage deals is 20×10=200 which is less than 250. That means the winner pays for the rest of the deals. And that is the model that I know works in early stage VC. Anything else is going to be challenging for the industry.

Are we in a valuation environment that is challenging for early stage VC investors? Yes.

I wrote in an earlier post in this series that friends and family is the most common form of startup financing. If you are talking explicitly equity investments, then that is probably true. But the most common way that startup businesses get money to get going is they sell something to someone. In this context, someone means customers.

Customers are a great way to finance a business for many reasons. First, customer financing is typically non dilutive. They want something from you other than equity in your business. Customers also help you fit your product to the market. And customers will help debug and improve the quality of the product. An early customer will give you credibility with other customers. And an early customer may spend more with your company down the road.

The most common way customer financing is done is you sell the customer on the product before you've built it or before you've finished it. The customer puts up the money to build the product or finish the product and becomes your first customer. Usually the customer simply wants the product and nothing more. At times an early customer might ask for some exclusivity on the product or even some free equity in the business, but most of the time the early customer simply wants the product from you and nothing more.

So why not take this approach with every startup? Well, it isn't always possible to find a customer who will put up money in advance of the product being complete and ready to use. It takes great salesmanship to convince a customer to buy something from you that isn't built or isn't finished. But even if you can convince a customer to do this, there are some negatives.

First and foremost, building a product explicity for one customer often makes it less applicable to the market as a whole. An early customer who provides funding to build your product will want the product tailored specifically for its needs. And a highly tailored product is often not well suited to a broader market.

Second, you risk building a "fee for services culture" in your company with this approach. Some companies build products for customers for a fee. Other companies build products and sell them "as is" to customers. The latter is the scalable model for building valuable companies. If you use customer financing, you risk being pulled into the former.

And customer financing is much more difficult, if not impossible, in consumer facing services. It is much more applicable in business facing services.

Those are the pros and cons of customer financing. If you can convince a customer to put up significant capital in advance so you can build or finish your product, you should consider it very seriously. Many great companies got their start this way.

I've been on a mission to dramatically reduce the legal costs of a venture financing. Our firm is doing our part. On many of our recent transactions, we've gone without counsel and have signed documents without negotiation. That takes out the investor counsel costs. And we've been pushing company counsel to reduce their costs. But we are still seeing company counsel costs of $15k or more on venture financings even with our "no negotiation" approach. I'd like to see venture financing legal fees get to $5k or less. I don't know why raising a venture round can't be like signing a lease on an apartment with standardized docs and a one page rider for any changes.

As we dig into the costs on the company counsel side, there are areas we feel can be improved and areas that cannot. The entrepreneur still needs an experienced counsel to explain the deal to them. That time and money is valuable to everyone involved. I'm hopeful that Brad and Jason's upcoming book will help reduce the time and money spent educating entrpreneurs on venture financings, but realisitcally the company counsel is still going to have to do some hand holding.

But there are many areas where the company counsel is spending time and money doing things that can and should be automated. Tops on that list is document creation, distribution, change management, and ultimately signing.

We've noticed that some of the new online funding platforms, like Profounder, have managed to totally automate this process online. We wonder why the law firms we work with have not. One of the best hacks of the Disrupt Hackathon last weekend was Docracy. I am going to find out if we can use Docracy on our next venture financing to make things more efficient.

And Bijan posted recently that he is using an iPhone app called EasySign to sign legal documents when he is out and about. After going through torture this weekend at our beach house to sign docs that absolutely had to be signed by yesterday, I'm searching for something similar on my Android. Please EasySign team get me an Android version. I promise I will blog about it when you do.

And in the meantime, if anyone knows of any good mobile signing apps on Android, let me know about them in the comments.

This whole area is so ripe for change. We are documenting financings for cutting edge web startups using technology from the middle ages. That must change and it must change now.

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.

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 firms typically don't hire very many people. But our portfolio companies sure do. So what you typically see when you go to a VC firm's website is a jobs page that showcases jobs from their portfolio companies. USV's jobs page is here. I blogged about it here.

Earlier this week Foundry Group rolled out a similar jobs page. Brad Feld blogged about it here.

As Brad said in his post:

This page is built on top of Indeed, in our opinion the best job search engine. We are not investors in Indeed, but our friends at Union Square Ventures are. They led the way on this one, working with Indeed and hacking together some code to make a dynamic jobs page. We looked at several options but kept coming back to the USV Jobs page. Kelly Collins and Ross Carlson in our office did all the work. They had help from Gary Chou at USV who generously provided all the code he’d written along with advice, as well as Matt Molinari from Indeed who helped Kelly and Ross figure out all the nuances of the integration.

If you would like a jobs page like the ones at USV and Foundry Group, we can help you get it done. Email me using the "Contact" link at the bottom of this blog and I will put you in touch with the people who can help you make it happen.

I talked about this book yesterday on stage at Disrupt and got a bunch of requests via email and Twitter for details so I thought I'd blog about it today.

Back in 2003, when Brad and I were starting USV, we were struggling to make sense of the bubble and its aftermath, what it meant for technology and what it meant for venture capital. If we were going to start a new venture capital firm, we wanted to start one that would be relevant, that would have a coherent investment thesis, and one that would make money for our investors.

Brad got this book from someone, not sure who, and when he finished it, he said "you have to read this." I did and it became the basis for much of our investment thesis. We concluded that the period of building and investing in the infrastructure of the Internet revolution had passed and it was time to invest in the application layer. But much more than that important and simple insight, this book gave us a framework to think about what the Internet was doing to markets, society, and business. We still refer to it frequently. And I think it is still very relevant to the environment we are operating in right now because the Internet is the mother of all technological revolutions and it is important to understand exactly what that means.

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.

Mark Suster has been writing and speaking out about the challenges of a 50/50 partnership between two cofounders. He makes a ton of great points. I would like to provide the counterpoint.

I've started two venture capital firms. The first with Jerry Colonna. The second one with Brad Burnham. Both were 50/50 partnerships. Both have been fantastic experiences. I knew Jerry for a few months before I partnered with him. I knew Brad for a decade but had never worked in the same organization as him. I recognize that venture capital firms are different than companies and that a partnership model works better in VC firms than it does in companies. But these two experiences have taught me that a 50/50 partnership, like a marriage, forces the two founders to come together on all the key decisions and can lead to better decision making.

When I look through the USV portfolio, I don't see a lot of 50/50 partnerships. Of the 38 companies listed on our website, only seven started out as 50/50 partnerships. But some of our best teams were formed that way. Paul and Rony, the founders and leaders of Indeed, are the iconic version of a partnership at the top of a company. They have built possibly the best all around company in our portfolio and they have done it via a partnership model.

Two other partnership driven startups come to mind as I think back over my investment history. Gian Fulgoni and Magid Abraham at ComScore has always been a partnership and they have built a fantastic company. And Jordan Levy and Ron Schrieber, the first entrepreneurs that I worked with as a board member, introduced me to the partnership model. They were even co-CEOs.

So while Mark is right that you don't need to be 50/50 partners with your co-founder, I would say that if you feel comfortable in a 50/50 partnership, it can be a terrific way to operate and build a business. It has worked very well for me over the years and when I see a true 50/50 team show up in our office, I am always more inclined to say yes. I have a great history and pattern recognition with this model.