Silicon Valley Frontlines

Founders Stock Vesting - Why It's Important!

Boy, the longer I deal with early-stage tech companies the more I'm amazed by the prevalence of teams that operate without founder stock vesting. 

As you know, most startups get going with a team of two or three folks coalescing around an idea - and then spending perhaps years, with their own sweat and nothing else, developing a product or service and getting it going to the point they can raise money and scale it up. Assuming they've addressed ownership at all then they've probably agreed some split based on contribution of effort and skills, and it feels equitable (not the same as equal) to all involved. Hopefully they also set aside stock for others they've hired along the way, or contractors paid in equity and so on.

That's good, as far as it goes. Where it falls apart is if that stock hasn't been subject to a vesting schedule. In essence the ownership needs to be EARNED over the time each person has been contributing, not just given up front. In the extreme case, without a vesting schedule you have the potential for the ugly situation where one founder may just decide he's had enough and moves on, leaving his two co-founders to carry on and make the business work. Is it fair that he walks off with all his stock and is not adding any more value, while the others remain trying to make theirs - and therefore his also - worth something? Obviously not. And not only that, its a chunk of ownership not now available to recruit a replacement. 

The standard approach is to structure founders stock just like a regular stock option - vest over 4 years with a one-year cliff. And the logic is the same - you gotta stick around long enough to start with to have made a real and substantial contribution to the company and your team members. Then you keep earning more monthly as you go. Leave at any time after one year and you get to keep what you've earned - no more, no less. Have an accelerator in there in the event that the company is sold, sure. 

Obviously this approach does not, per se, apply to a solo founder for obvious reasons - but most startups are founded by teams and they must address this question. 

One objection some founders have had to putting these structures in place is their fear of the cost and complexity - and when you have no cash its hard to think about paying lawyers to do this stuff. Frankly, that's a non-issue. Reputable Valley firms will help you set this up for deferred or no fees at all, or you can simply go to my friends at Orrick who have set this up online for you for free (but consult them if these don't fit your situation). Go here to go through the Q&A process and create your Founder Term Sheet (in essence defining the founders, their ownership etc) and then here for the various legal agreements to document the deal. There are other similar sources out there if you look around. 

So now you have this in place. Lets say that helps encourage everyone to be in the boat pulling hard to make it worth something. Well, in my next post I'll discuss what happens to all this when you raise venture capital ... and it may not be what you think!

The Ten Hottest Private Companies in Tech - Good News for the Valley in 2011?

The good folks at Mashable just published a list of the Ten Hottest Private Companies in Tech, based on a survey by SecondMarket. SecondMarket is a rapidly growing exchange offering (among other things) the opportunity for sellers and buyers to trade private company stock prior to an IPO or other typical public liquidity event. (We can discuss another time how these exchanges operate but they are indeed offering a valuable service to liquidity seekers and prospective buyers). SecondMarket surveyed their buyers and potential buyers about these companies and, In order of most- to least-interest, they are:

1. Facebook
2. LinkedIn
3. Twitter
4. Zynga
5. Craigslist
6. Groupon
7. Yelp
8. SecondMarket(!)
9. Pandora
10. Bloom Energy

As an avid Silicon Valley fan, I love the fact that all except Groupon and SecondMarket itself are Valley companies. And all, except possibly the wacky guys at Craigslist, represent possible IPO opportunities in 2011. And this doesn't even include Skype (new headquarters in Palo Alto; IPO about to spring loose), Art.com, MedeAnalytics (both East Bay) and others in the wings.

Five great outcomes of some or all of these IPO'ing in 2011:

1. Liquidity events are a key driver of VC investment sentiment. While much of that liquidity happens through M&A activity, the big splashes and payoffs from IPO's will enable portfolios to show substantial returns, raise new funds and have the confidence to invest in new startups or growing existing ones.
2. More cash into the Valley economy from employees selling stock, hopefully stabilizing and improving the housing market and the general ecosystem.
3. Greater momentum on the job front as newly public companies scale up with the proceeds (at this stage they are not cash hoarders like the Apples of the world!).
4. A boost to the California economy and budget. Not only does the ripple effect of spending spread across the state but the taxes paid by employees and others in exercising and selling stock would be substantial. In 2006 California personal income tax receipts grew by $4.3 billion from the prior year due in no small measure to employees and others selling their Google stock. During that time Google's market cap grew from $70 billion to $100 billion - and as it happens many people believe Facebook is already approaching the lower number in that range.
5. Talking of which, one benefit is that it would not be all about Google any more ....!

Agreed, all this takes time to ripple through the system. For example, shareholders in an IPO usually have to wait 6 months in a lock-up period before they can actually sell. But sustained benefit over a long period is better anyway ...

Related articles

• The 10 Hottest Private Companies in Tech [REPORT] (mashable.com)
• SecondMarket Releases Q3 Private Company Stock Trading Report (eon.businesswire.com)

"What's So F***ing Special About You Then?"

When I first moved to the U.S. from England many years ago - more than I care to remember - I needed a visa to work here. The company that hired me brought me in under an H-1, which is the visa category reserved for people with highly specialized knowledge in certain fields or, as my immigration attorney put it, "aliens of distinguished merit". It was a rather flattering description of someone who, at the time, was a young professional really starting out in his field but who was I to argue if it worked?

My job at the time involved international travel and on one occasion I came back into the country through Honolulu so I could take a few days vacation after a business trip to Japan. Anyway, I'm at the immigration officer's booth at the airport and present my passport, my visa and my letter of employment. The officer studies these for a moment and then leans over the counter, looks me in the eye and, very loudly, asks "so, what's so f***ing special about you then?" Which took me - and the people around us - back a bit because this is not typical of the almost universally-polite immigration officers I have met before or after (except in Miami, which is the worst port of entry to the U.S. by far). However, before I could respond, the guy burst out laughing and waved me through with a "welcome home!".

In retrospect this officer would make a pretty good VC. I've heard many different statistics but one is that the average VC may look at 3,000 business plans or in a year and invest in three. Which means saying "no" roughly 999 times out of 1,000. As an entrepreneur that doesn't mean your odds of getting funded are just one in 1,000 but it does mean you'll likely kiss a lot of frogs before you do get funded. But if you do want to get funded you in essence have to be able to quickly convince a potential investor what's so f***ing special about you as opposed to all the other opportunities he or she could invest in.

Which means your first exposure to an investor, often through an executive summary forwarded by someone they know (as opposed to your out-of-the-blue submission), needs to be strong enough and clear enough to grab them by the throat and convince them that this is worth looking at and taking a meeting. Then, as I've written before, when you get the meeting you need to be ready to go full-bore on your idea and what makes it - and your ability to execute on it - so special.

There's still hesitancy by some entrepreneurs - "I'm saving the demo for the second meeting" or "I don't want anyone to steal my idea". Well, VC's are not in the business of stealing ideas - they invest in them (or some will actually say they invest in the team more than the idea in many cases). In fact, if they did make a practice of stealing ideas then the word would get around pretty quickly and that would be highly negative for their business. They are investors so they need to hear the idea very clearly and, if possible, see it in action and some proof points if you want them to do what you want - which is write you a check!

In the last few weeks I've had the discussion about being very clear in an exec summary or pitch with a relatively new reader of my blog who lives outside Dublin, Ireland. She wants to raise money for her startup focused on interactive on-line educational programs in the arts and sciences for children. For her this is even more critical because her physical location makes it difficult to quickly get in front of many likely investors and because it's not the most obvious venture investment opportunity given that its more about approach, content and curriculum than a technology per se.

Her draft was a good start - except that it was not clear what specifically the "secret sauce" or differentiation actually was. As we've started to refine this together we've added that clarity, made it more of the focus (as the solution rather than the prior emphasis on the problem) and then addressed the key issue of how to get the content into the marketplace and adopted. Much of this has taken stuff that had already been thought through but, as she said to me, was in her head and needed to get into the pitch in a brief and compelling way. As we develop this further I think we'll have something that is far more attractive for early stage investment with the right partner or group of angels. In other words its starting to feel, er, special! Now we'll have to see if others do too ...

IPO's and M&A Exits Continued to Improve in Q3 ... Good News for the Trickle-Down Effect

As noted many times before, the availability of funding for startups is heavily influenced by the state of the market for exits - IPO's or acquisitions. If investors don't think they will be able to exit an investment down the road then they won't tend to make it in the first place (duh!). Somewhat illogically, this has very immediate impact on new investments even though the exit will be years down the road and subject to whatever market conditions then exist, going to show that emotion and sentiment is still a significant factor in current decisions.

They good news in Q3 2010 is that while IPO's continued to improve from last year, the sales of venture-backed companies in M&A activities (including two of my prior startups or clients, yea!) increased substantially. This has the effect of (eventually) encouraging more money to go into startups as individuals cashing out then start new companies or become angel investors, and from traditional VC's seeing positive outcomes. In addition more money comes into the local economy from employees and individuals cashing out and buying houses and cars and the usual trappings of success/hard work. (Of course, IPO's aren't strictly exit events but for most earlier-stage VC's they are the start of that process).

According to Thomson Reuters and NVCA there were 14 venture-backed IPO's in Q3, for a total of 40 for this year-to-date, compared to just 18 in 2008 and 2009 combined. The average IPO took 6.7 years and $51m in funding to get there. An additional 49 venture-backed companies are on file with plans to IPO in the near future, representing a healthy pipeline for the rest of the year and into 2011. And of course not including - yet - Facebook, Zynga, LinkedIn or some other hot Valley companies!

Total M&A deals involving venture-backed companies in Q3 were 104, and 322 year-to-date compared to 173 in all of 2009. Two-thirds of the 104 were for computer software or internet companies. The average time it took a venture-backed company to achieve an M&A exit in Q3 was 4.8 years (20% less time than last year's exits) and an average of $23m in venture capital to get there (versus an average $27m in exit proceeds). The latter suggests that on average VC's don't make much money on their investments so it's interesting to look at an analysis of the values of the transactions versus the amounts invested in these companies (so much for averages!):

Analysis of Transaction Values versus Amount Invested
Relationship between transaction  value and investment		Q1 10 M&A **		Q2 10 M&A **		Q310 M&A **
Deals where transaction value is less than total venture investment		9		3		7
Deals where transaction value is 1-4x total venture investment		7		4		11
Deals where transaction value is 4x-10x total venture investment		9		9		4
Deals where transaction value is greater than 10x venture investment		4		4		5
Total Disclosed Deals		29		20		27
Source: Thomson Reuters & National Venture Capital Association

I'd expect the overall M&A trend to continue and even accelerate as large tech firms, flush with cash, put some of that money to work (as they should do in the interests of improving stockholder returns over time rather than just punting with stock buybacks or starting to pay dividends). 

The reality is that, despite the improvement, an IPO continues to be a hard way to find an exit with more and more companies tending to sell themselves (as we see above) or delaying or avoiding such events until they literally have to. You may remember Google's IPO timing was heavily affected by the company getting to the point of having more than 500 individual stockolders, a key statutory threshold for being considered "publicly held" and almost by default. Facebook has avoided this by allowing big investors to come in and provide liquidity in the near-term to certain employees and others in private transactions and I'll discuss more of this in a future post.

Sources: Thomson Reuters, National Venture Capital Association and Dow Jones VentureWire

Top Ten Start-Up Mistakes. Not What You May Think! Part Two ...

Ok, here's my belated follow up and conclusion from Part 1 of Top Ten Start-Up Mistakes from the Orrick event last month!

Mistake #5: Not Recognizing When to Supplement or Shrink the Team

Founders who fear bringing in the right people at the right time are a problem. "When I find someone as smart as me then I'll bring them in" - wrong! Engineer founders generally don't know how to build sales and marketing. The culture you want determines the kind of people you hire. You should always be hiring or shrinking - but make sure the people are the right fit (don't hire guys with machetes if you are already on the highway). Personal characteristics and motivation are always the most important, not the specific skills - you can learn the latter but not the former.

Mistakes #6 and #7: Not Having a Real Plan - and Not Knowing Where You Are On Your Roadmap

A key emphasis here was to insure you figure out what type of business you are building - a big or small company, a home run or a single. This is really important because it determines much of what you do - and who you hire and whose money you take. The reality is the vast majority of startups that succeed turn out to be single. Very few ever IPO (fewer than ever). Most will get acquired if successful. And for you as a founder you may be a lot better off taking smaller money from angels or smaller vc's, controlling your destiny more and getting a larger share of a smaller business (and more total dollars) than someone who swings for the fences and even if successful gets a very small piece of that bigger business. Regardless, you need to build your business to be independent, not just to be bought. 

Always have a clear plan - but be nimble enough to change it if you need to. If revenues are less than you planned then you need to find new growth or cut expenses. This is partly why investors bet on people - things rarely go according to plan and how the people handle it is key. Knowing where you are on your roadmap then becomes key - is your hypothesis (for that's what it is) working or not? By the way - as I've written about before - tying funding to milestones is wrong, not just because its a cheat on valuation by the investor but because you may need to change the plan and the milestone becomes a millstone.

However metrics are important. Here's what we said we'd do. Here's what we did. Here's what we're going to do next. It's your feedback mechanism. Why is something drifting? Be ready to reset if needed, or take other action. Be super transparent, regular, communicative and avoid surprises.

Mistake #8: Being Penny-WIse and Pound Foolish

As a financial advisor and CFO to startups of course I have to echo the starting point on this one - the panel's statement that you need to have a good CFO or Controller. It's still a surprise to me that so many startups don't have either one - and in fact frequently don't even have a good bookkeeper or basic financial information available. The panel view was that you need someone on board who doesn't want to spend money BUT the real key is someone (CEO's are often not the right ones) who can help make the right trade-offs. After all, saving $5k a month in online marketing is a false economy your total burn is $150k/month and not spending the $5k means you take X months longer to make your target. Not having a top sales person is a bigger mistake than having a colour copier. I'll repeat a personal view here: the right financial person on board (emphasis on RIGHT) will pay for themselves many times over in better business decisions and return on investment. 

When you have raised money (see below) then have self-control and don't defocus. If your plan said you would spend $Y on marketing and you raise the money you needed then don't go spend that $Y on swanky new space instead.

Mistakes #9 and #10: Never Be In The Position Where You Have No Money; Don't Raise Too Much or Too Little

Sounds obvious. Amazing how many don't figure it out. Cash is the rocket fuel so you need to raise it. Be sure you know you much you need to get to the next key funding milestone - then raise more because it will take longer than you think to achieve that milestone. But also, raise money when you can, not when you need it. Timing is a key factor - not just in your business but when the market is more ready to supply funds is critical. 

Be forced to make tradeoffs and prioritize. Be very lean during product development and market discovery, then accelerate to ramp up the customer acquisition and returns.

Raising lots of money at a high valuation means you need to have a big exit. This will NOT happen for most companies. Solid singles (an exit in the $50 - $100m range) are a great result for most people. When raising money don't obsess on valuation. Take a reasonable valuation and focus on increasing it solidly between rounds. Down-rounds are viewed very negatively (in fact they can be the kiss of death).

Finally, raise money strategically. This means raising based not just on cash needs. You need to have in mind what business you're building over the longer haul, who the investors are and what they bring to the table that can truly help move the business froward. Yes, terms are important but get a win-win-win out of it.

Top Ten Start-Up Mistakes. Not What You May Think! Part One ...

I spent some time at Orrick's "Top 10 Start-Up Mistakes" event this morning, part of their Total Access series. Despite their size Orrick is a great law firm for early-stage companies (they have a dedicated practice for that group under Don Keller, who was partner on my first startup in the late 1990's) - unlike some other tech law firms who have become too big and arrogant for the little guys.

Panelists today were Ann Miura-Ko of FLOODGATE (formerly Maples Investments) and Howard Hartenbaum of August Capital, along with George Garrick, CEO, Offerpal Media and Gary Swart, CEO, oDesk.

As we know there is no limit to the ingenious ways people find to royally screw things up - as a start-up or anywhere else. As one panelist put it, experience is what you get when you fail to get everything else you wanted so, in lieu of learning the hard way, learn from others! In order of importance, most important to least (of the Top 10), here's what the panel said. I'll cover some of them today and some in my next post.

Mistake #1 (The Worst): Burning Your Bridges

Paraphrased, this came out more as "live by your word and act with integrity". Interesting #1, this, because its not limited to startups, obviously. In the world of startups, however, there are many inexperienced people, sometimes significant personal money at stake, lots of uncertainties and a huge amount of trust needed between investors, boards, founders and employees to pull it off.

This can cause people to behave, lets say, in a manner which is less than desirable or ethical. And outsiders sometimes take advantage of this (example quoted: Facebook's and Microsoft's habits of structuring acquisitions to offer more value to key people they want to keep going forward, vs. the deal already agreed between the investors and the founders/employees).

The point comes down to this. As you go into this with your team - all of the stakeholders - keep your word, make sure everyone feels good and properly treated and take care of your reputation. If you shake hands and then do something different it will come back to haunt you.

Mistake #2: Not Focusing Nimbly

Focus is critical in startups. Its very easy to get distracted, or overreact to outside factors. That said, the reality is that things change as you go along. So you need to be highly focused, yet nimble enough to change tack if something happens to significantly impact your plan. Fact is, many successful startups never set out to do what they ended up doing.

Ann Miura-Ko from her investments: Chegg was Craigslist for Colleges - until Facebook started doing it, so now it's textbook rentals for students; Circle of Moms was started as Circle of Friends by two young, single (no kids) guys as a way to create groups on Facebook, so when Facebook started doing the same thing they focused on Moms as one of the key active large groups that formed under their prior plan. (Hmm, notice a theme in Ann's investing??).

Focusing nimbly was also defined by one panelist as being able to say what you do clearly, in one sentence. Focus certainly, not sure about the nimble ...

Mistake #3: (Not) Letting Your Investors Become Your Trusted Advisors

This one actually focused more on developing the right dynamic between you and your Board/investors. A consistent theme was along the lines of "well, you (the CEO/Founder) are in charge and you need to run the company", with of course the caveat that if we don't like what or how you do it then we'll take you out. Reality is that you need to pay a lot of attention to who you take as your investors and how the dynamic will play out. Many investors have two completely different sides - when things are going well, and when things are not. So check out both sides with people who have worked with both sides - before you take the money.

If you need more help from your Board or investors its OK - to a point. Introductions to potential partners? Great. Taking over running the business - not good. It all depends on the timing, the relationship and the needs. Generally investors want you to listen to what they have to say, but not be told what to do (otherwise they should get someone else). So you have to figure it out but with their advice and input.

This also helps with one key point: never surprise your Board! Always keep them in the loop, knowing what's going on.

Mistake #4: Not Having Trusted (Valuable) Advisors

Naturally I like this one (becoming a trusted advisor - and earning that role - is one of the ways I help startups myself). And I agree with it because even experienced entrepreneurs don't know it all. They tend to know a few things well, and the rest has to come from around them - the team, the investors/Board and the trusted advisors.

In this case "trust" means "valuable". They need to add true value. If they are just names on paper to look good then they're just endorsements -and largely worthless. They need to be real help to you. You should hire an advisor the same way you hire an employee - carefully, with reference and other checks. Paid or unpaid, cash or stock, depends on the value and the role. 

However advisors will get frustrated and move on if you don't know how to use them, receive the advice and know how to parse and act on it. This does not mean blindly following the advice. But if you ask for advice then please accept it and decide how you will use it. And don't try and do it all yourself.

More in the next post!

Why Silicon Valley is Still the Only Silicon Valley ...

One of my LinkedIn groups, "European Entrepreneurship & Innovation @ Silicon Valley" has an active discussion thread going on about where the next Silicon Valley might be. I thought it would be interesting to share with you my own contribution to this ...

I've worked a lot with startups in Silicon Valley and have close connections with the Plug and Play incubator in Sunnyvale as well as throughout the ecosystem here. While I agree that things are steadily improving elsewhere (and Plug and Play itself is trying to expand it’s concept outside the U.S.) there is lots of evidence that creating another “Silicon Valley” elsewhere still has a long way to go.

As evidence, I’d point to the significant and rapidly growing group of European startups coming to the Valley, from Barcelona, Austria, Rome, the UK and elsewhere. Their reasons for coming here? In their home countries or generally in Europe the ecosystem of funding, expertise (particularly management expertise), talent, mindset, advisors, legal and so on is still far less well-developed than here in the Valley. The fact is that it’s still incredibly difficult to build a successful business from scratch even with all the tools and resources such as cloud-based platforms available today and a lot of it is nothing to do with the technology itself.

The SV ecosystem is still second to none in helping in the broader aspects of this. In almost every case I’ve seen the only local advantages in Europe seem to be lower cost structures (a SW developer outside Rome costs $30k a year, same as an outsourced India person and a lot less than the Valley) and government-backed loans (if you have the patience of Job). On top of which too many prospective employees in these locations just want a 9-to-5 job with benefits (not the go-for-it mentality of startups in the Valley). And labour laws prevent you getting rid of them if they don't work out.

Another example - a local VC in Spain taking the attitude of "if I invest and you leave, then the equity you already earned and vested comes back to me". So, I punish you if you leave. What kind of stupid attitude is this? Why would you join the company in the first place? I don’t know any Valley VC who will do this – or even think of doing it. Golden handcuffs inasmuch as you earn and keep more the longer you stay, and topping up the options regularly – yes, here in the Valley. But not over there, apparently.

Yet another example - you can incorporate here in the Valley overnight with the help of a top-notch Valley lawyer from Orrick (who will do this for free and a $600 filing fee). OK, his time is minimal and he wants the relationship. But try doing that in Rome or Barcelona or Prague and they look at you like you’re mad (and you would be).

If other locations are really becoming new Silicon Valley, then they would start to siphon off a decent share of the financial lubricant needed to prove an idea and scale it up as a business. Do they? I don’t think so. According to the NVCA about 276 Silicon Valley deals raised $2.92 billion in Q2 2010 versus 216 deals that raised $1.57 billion in Q1 2010. Part of a general recovery? Yes. But in bigger picture this is almost half all the VC money invested in the total U.S. ($6.52Bn) going to the few square miles of the Valley. According to Dow Jones Venture Wire “Venture investors put €1.1 billion into 289 deals for European companies during the second quarter of 2010”. Even though this is a 50% increase over last year its still saying that all of Europe raised less than half the money going into Silicon Valley. China? Raised $689m in the same 3 months. Less than a quarter of the SV amount.

So, who is winning the fundraising game? Today anyway …

Don’t get me wrong. It would actually be a wonderful thing if there were Silicon Valley's in Poland or Abu Dhabi or Kandy or Phuket (my vote). And yes it is slowly changing out there. Not just in Europe - Asia is following suit. But they’re all still a long way from being in the same league as Silicon Valley.

My prediction is actually a bit different anyway. I think the truly successful startups will become multinational early in life and stay that way. They may be headquartered and funded in one place – maybe Silicon Valley or London, develop their software in another – maybe Prague or Hanoi (with employees motivated as part of the global team, not outsourced coders who don’t give a hoot who they’re working for), partner globally and locally and be connected directly with customers all over the world. But that’s not the old 1000+ person multinational. This is 15 people in a quasi-virtual organization yet all bound together with a common identity. And of course this is how we’ll really bring the world together in the future!

Marc Andreesen - Entrepreneurial Thought Leader!

I'm startled to see how long it's been since I last wrote in this blog - almost 2 months! There's no shortage of interesting things to talk about, just a severe shortage of time to do so. I suppose it's a good thing because, frankly, I've been busier than the proverbial one-armed paperhanger. Lots of people needing help and I'm just happy to be asked to give it!

I did take time out a couple weeks ago to go see one of my favorite Valley entrepreneurs, Marc Andreesen, the Netscape, Opsware and Ning co-founder who now runs his own venture capital fund called Andreesen Horowitz. Marc was speaking at a Stanford University Entrepreneurial Thought Leaders seminar and it's always worth listening to what he has to say. In no particular order here are some of his topics and thoughts (excuse the paraphrasing). 

On the venture capital industry:

Interestingly enough, you need a license to have a gun or to drive a car. You don't need any kind of license - or indeed any specific background or expertise - to become a VC!

As an investor, most VC firms will break your heart. It's well documented that majority of VC returns are made by the top 20, 30, 40 firms and the other 700 or so will significantly under-perform the market at vastly higher risk. (He implies this is a badly broken model).

Because it's so much cheaper these days to get many companies started and ramped up than it used to be, there is a whole new layer of seed and Angel investors coming into the market and in essence displacing some of the traditional VC roles. And at the other end of the spectrum there are new firms coming into the market and investing hundreds of millions of dollars in much later stage companies like Facebook, Zynga and Groupon with the specific objective of providing liquidity to founders and employees and allowing these companies to stay private much longer than they would have historically done. (Being public is absolutely not all it's cracked up to be!)

Three necessities for a successful startup:

1. Is there a big market? An existing one, or a brand-new one.
2. Is what you bring to the market enough to provide a 10x change as a result of your product, technology or innovation. It has to be significant enough to create a brand-new market, or be able to punch through and displace existing, entrenched competitors.
3. Team. Preferably more than one technologist, and somebody who knows how to sell!

How to attract the best and brightest to your startup:

Stock options, yes, sure. But you really need a great vision. "The difference between a vision and an hallucination is that other people can see the vision!" It's a sales job. The entrepreneur must be able to create and sell that vision in a compelling enough manner to get everyone else - investors, employees, customers - to go along with it and help make it happen.

The Valley as the world's center for consumer electronics:

Marc believes that the combination of incredibly powerful chips and components, almost as commodities, and the design skills and software innovation here in the Valley is shifting the center of gravity for consumer electronics back here from Asia. Firms like Apple, yes, but also Mino (Flip cameras), Aliph, Palm, Tivo, Sling and many more. While they look and feel like hardware companies in reality their strengths are in the innovative product designs, software capabilities and related services (app stores, iTunes etc) these companies bring to the table.

For example, Aliph's Jawbone Bluetooth headset now comes with an app store where you'll be able to download apps that can do things like read you directions as you're driving, read you your email, etc.

Entrepreneurship "in the cloud":

Many of these consumer products companies - and others - are doing their software development in the cloud, particularly using Amazon Web Services. This has eliminated much of the traditional high costs - servers, software, bandwidth etc - associated with starting up technology businesses, allowing these companies to be much leaner, take less capital and scale up more rapidly.

There's lots more but you get the flavor! To see Marc's talk in its entirety look here at Stanford's Entrepreneurship Corner. If you missed his interview on Charlie Rose on PBS last year, go check it out here. 

Solyndra's IPO - Not a "Going Concern", But Hoping It's a Big Success!

As I've noted before, there are many companies now in the backlog of IPO's filed but not yet completed. One of them, the cleantech company Solyndra, is worth taking a closer look at because of its rather unique characteristics. This high-profile solar panel business has raised a whopping $961 million in venture financing since it began and has been in registration since mid-December last year. It's looking to raise about $300 million from the public offering. Sound like a lot? Well, yes, but they need a lot!

Since introducing it's unique cylindrical components and related panels Solyndra has grown revenues from zero in 2007 to $6 million in 2008 and to $100 million in 2009 - astonishing growth but for the unfortunate fact that it still costs the company a lot more to make the panels than they can sell them for. For that $100m in 2009 revenues it cost them $162m to manufacture the product - and then another $115m to develop, market, sell and cover overheads. So for those at home keeping score they spent $277m to produce that $100m in revenues. It's still better - relatively speaking - than the $228m they spent in 2008 to produce just that $6m in revenues ....

This is not a typical business, even for the sometimes-extreme Valley! Here's a company whose products are clearly state-of-the-art but where, after raising and spending almost a billion dollars, the true economics of producing and selling them are yet to materialize. In fact their auditors PriceWaterhouse Coopers, have just issued what's known as a "going concern" opinion about the company. To backtrack for a second, all companies looking to go public via an IPO have to file an S-1 registration statement with the SEC which has to include three years worth of detailed, audited financial statements along with an additional two years of summary financial information, assuming the company has been around that long. As part of those statements the auditors issue an opinion, basically saying that those statements fairly represent the historical financial position and results of the business.

While this opinion is largely a rear-view mirror look the auditors are required to do some procedures to determine whether it is able to operate as a "going concern" in the future as a viable stand-alone business. The typical approach - and rule of thumb - is that it is is a going concern if it has enough cash on hand to run the business for twelve months from the date of the audit opinion (in essence, the date the auditors sign off on the period they just audited). The auditors won't be able to assume future additional financing (including the IPO) because that may not happen. Nor can they assume some rapid growth or improvement in the business that suddenly makes it cash-flow positive. The most likely thing is that it continues as it just left off in the most recent year. So lets look at some of those numbers. 

In the year ended January 2, 2010 it spent $170m in cash just running its daily operating activities (basically the loss it incurred in selling the $100m of product plus its operating expenses and various other adjustments). It also had to build it's production facilities and make other capital investments - which totaled another $175m. So there's almost $350m - millon! - of cash consumed in one year.

How did they finance that, because the money came from somewhere? Well, they raised $336m in venture financing (part of the $961m I mentioned above) which included converting some existing loans into equity (an ownership stake), and took on an additional $140m in debt. That debt is worth looking at - its money they have borrowed against a $535m loan facility guaranteed by the Department of Energy and is money coming from the Federal government's economic stimulus and recovery commitments. It has to be used for the building of Solyndra's second production plant in the Valley (those of you who regularly travel on Highway 880 in Fremont will see the first plant right by the Eastern side of the road) and which Solyndra itself must finance at least 27% on its own in addition to the DOE guaranteed loans.

At the end of 2009 where did all this leave the company? Well, it had $50m cash in the bank (it also had $151m of further cash on the balance sheet, but that cash is restricted and can't be used for regular operations). And the customers who bought the $100m in products still owed it $34m in remaining payments for them. Against that it owed $105m in current liabilities (payments for product costs, purchases, etc) and $140m in long term debt (the money borrowed above). Not exactly a lot of net cash on hand to pay the existing bills and then run the 2010 operations.

When you look at all the numbers, and you add to that the complexity of the business, the risk factors (their S-1 lists 24 pages of them!) in the technology and the marketplace, then on a pure business analysis you have to agree with the auditors - they are not a going concern. It's also not unusual for a Silicon Valley early stage company (and it is still very early in the development of this technology and it's market) to be in this position. In fact, that's exactly why they need an IPO - to raise the money for growth and to get to cash flow positive from operations. But its pretty unusual for a company to take the step they just did - publishing an open letter to their customers and suppliers to explain why, in their view, this is not a problem.

To take a closer look at their SEC filing, click here.

I'm rooting for this company. It's in the forefront of developing new energy solutions we desperately need. They claim that "by the end of 2012, we will be able to deliver photovoltaic systems that produce electricity on commercial rooftops at rates that are competitive with the retail price of electricity in key markets on a non-subsidized basis". I'd love to see that! They employ 800 people, mostly in the Valley. Many of those people are in manufacturing - a segment hard hit since 2000. That number will increase with their second plant and further production ramp up. This is the kind of business the Valley needs, and needs to be successful. And the country needs the technology.

Still, a lot of people will have to make some pretty big bets to pull this off!

Financing Improved In The Fourth Quarter - And So Did Valuations And Deal Terms

In my recent blog I noted that the volume of venture financing completed in the fourth quarter of last year improved somewhat - at least compared to the experience of the previous 9 - 12 months. [I also said that my next post would be on some of the gathering clouds in the Valley funding picture - I'm deferring that for a moment while I fill in some other fourth-quarter details first].

Perhaps even more encouragingly than the simple volume of financings, the terms under which the fourth-quarter deals were completed also showed significant improvement, according to a report from law firm Cooley Godward. For example, the median Series A round was done at an average valuation of $6.15 million - an improvement from the average $5.0 million in the first three quarters and moving back towards the average $7.0 million seen in the prior three years. Similar improvements were seen in Series B and higher rounds as well. Notably, however, in 2009 there were only 11 deals done a at a pre-money valuation of more than $100 million - far fewer, not surprisingly, than the 188 such deals done in the three years 2006 through 2008.

It’s also encouraging to see that the percentage of up-rounds [rounds completed with an increase in valuation from the prior round] improved to 45% in the fourth quarter compared to just 26% in the prior three quarters. While this is still short of the 60 to 80% up-round versus down-round ratio seen in prior years, things have clearly stabilized and improved.

Liquidation preferences continue to be done largely at 1x, although in the fourth quarter was a slight increase in the proportion of series A deals done with between a 1x and a 2x preference. [In simple terms the liquidation preference represents the multiple of the money put in that an investor gets back at a liquidity event, such as a sale of the company or an IPO]. These liquidation preference multiples are still far better than the 3x or more that we used to see in 2002 through 2004 after the dotcom implosion. 58% of the deals done in the fourth quarter included fully participating preferred-which is pretty much the same level as we've seen in the last four years. In simple terms participation means the ability of preferred stock to share in the liquidity proceeds alongside common stock, after the payment of their liquidation preferences.

In non-financial terms, the number of deals with pay-to-play provisions declined in the fourth quarter compared to recent history, while there was a continued increase in the proportion of deals done with drag-along provisions. [Pay-to-play provisions are typically used to motivate investors to participate fully in their pro-rata percentage of subsequent financing rounds, while drag-along provisions are employed to insure that a majority of investors may force a reluctant minority to pursue a liquidity event, for example].

There are various other items worth looking at in this report, so I’ve attached a full copy. Enjoy!

Download Cooley Godward Q4 2009 Venture Financing Terms

The State of Play in Silicon Valley Venture Funding - Clouds on the Horizon?

I went to a session the other day to get the update on PriceWaterhouse Coopers quarterly "MoneyTree" VC funding trend report and thought you'd be interested in some of the observations. If you're in the Valley and likely to be raising money you need to know what's going on out there. So here's the update for Q4 2009 and the year as a whole:

• In Q4 about $5.0Bn was invested in almost 800 deals - a dollar amount in line with Q3 and about 100 more deals being done.
• For the year 2009 a total of $17.7Bn was invested in startups by VC's - the lowest since 1997 and $10Bn less than in 2008.
• 38% of the Q4 number, and 40% of the full year, was invested in Silicon Valley companies, with an additional 15% and 10% respectively in the rest of California. So CA-based businesses account for about half of all U.S. VC investing. By comparison in 2009 just 8% was invested in the NY Metro area and 12% in New England (Boston).
• The number of Valley deals done in Q4 was around 260 - better than any quarter since Q3 2008 and on a par with the rate of deals getting done in 2006
• Early stage (Series A rounds) bounced back in the Valley in Q4 after a dry Q2 and Q3 - good news for newer startups.

Despite the efforts of many regions to create startup hubs and try and replicate the Valley, the share of funding taken by startups in Silicon Valley has been increasing steadily from 23% in 1995 to the 40% mentioned above in 2009. 

Sounds like we're turning the corner on the pace of investment and that the Valley continues to lead the geographical pack substantially. However, if you just pay attention to the dollars you miss a big theme - which is that the bulk of the money gets sucked up by the major capital-intensive segments in the Valley. These are Biotech, Medical Devices and Cleantech. If you're in those businesses you need lots of capital to develop products, gain regulatory approvals and so on - and the good news is that they were getting funded. The growth of these sectors is also a key element in the increasing SV share of funding I noted above. You don't have to go back far to remember the days when the number of companies in those sectors could be counted on the fingers of one hand - Genentech (now wholly-owned by Roche), Acuson (now Siemens) and a few others. And of course Cleantech, as such, didn't exist at all. The diversification of the Valley away from semiconductors, computer and then networking equipment manufacturing towards these newer, major segments has been a huge boon and, again, evidence of the ability of the Valley to reinvent itself time and again.

All that said, the software/internet space still had 177 companies funded in Q4 in the Valley for almost $1Bn (one third of the 2009 total) and the number was a 22% increase over Q3 of 2008. In 2009 as a whole the 619 software/internet companies funded was a 40% decrease vs. 2008. So Q4 was a good exit to the year in this segment. And its still clear that, despite the ease with which many startups in Internet, Social Media, Software etc can get started pretty much anywhere, the majority still get started and grow here, in Silicon Valley.

So where does that leave us? Well, things are definitely better than a year ago. However the panel discussing the results was largely gloomy about the outlook. And not just for this year, but particularly for 2011. In my next post I'll summarize the panel's opinions and add some of my own. Its enough to say that if you can get funded this year then take as much as you can while you can because the longer term has many clouds forming ...

Why Do Otherwise Sensible Companies Not Have CFO's?

The Canopy Financial fiasco (see my posts from late last year) highlights a very basic question (in that case, among many basic questions): "Why do so many fast growing startups not have a CFO?"

Here's an interesting table (I think it's from Ernst and Young, one of the Big 4 CPA firms, via the J. Robert Scott CompStudy):

As According to this only 17% of startups have a CFO when they have done one or fewer rounds of funding. In most cases this is probably appropriate - these companies tend to still be at the pre-revenue, product development stage and the business is pretty simple.

By the second and third rounds of funding, however, most of these companies are now generating some level of revenues and starting to grow and scale the business. Yet only 56% have a CFO. And only three-quarters of them have a CFO after 4 or more funding rounds.

To me this is bizarre. There are so many requirements piled on a business that need a dedicated CFO to help handle - revenue recognition, external audits (often a mandatory investor requirement as a condition of later-stage funding, though not always enforced), business planning and strategy, pricing, international structuring and tax planning, compensation structures, internal controls, economic models, budgeting, HR compliance etc...

So why do people not have them? I think its a combination of the following:

1. Lack of experience at the founder/CEO level. Not knowing what's important in managing the broader growth challanges of an early-stage business and the need for checks and balances, particularly in rapidly growing, multi-location companies. By the way, lack of experience doesn't just mean few years of experience. The challenge is also often true with an experienced sales or marketing executive turned into first-time CEO, for example.
2. Pressure to keep costs low and spending focused on product development and customer acquisition (sales and marketing). Unfortunately this is often encouraged by a company's Board - people who should know better about the need for checks and balances but often tend to be way too focused on minimizing unsightly or "unproductive" G&A overhead.

You have no idea how many companies I've seen over the years where some combination of these two factors has resulted in substantial problems later - restatements of financials (sometimes material enough to change an investor's view of the company's results), businesses with poor balance of resources, out-of-control compensation structures, untenable long-term economics, screwed-up equity structures, bad borrowing decisions, etc.

In the case of Canopy Financial they had, at some level, thought about the need and done some initial looking - as I know from my personal experience. But it clearly was not as high enough a priority as it should have been, and it took the appointment of new in-house legal counsel to blow the whistle on the problem. I guarantee you that a strong CFO hired a lot earlier would have discovered the problem before it escalated so significantly - and perhaps prevented it altogether.

So I know its self-serving to some extent but - please! - bring in the right CFO-level help at the right time. If its too early for a full-time person there are many well-qualified part-time people available. The cost of not doing so may be substantial - and not just the cost of fixing things. In the case of Canopy, it was disastrous.

Two Tales of "Working For Equity" ...

Working for equity only is, realistically, the way most startups have to get going. True founders - the gritty, enthusiastic, determined, change-the-world, passionate types - will do this for a long time, including well after they start paying others on staff some real cash. While there have been times in the last dozen or so years, usually during times of venture capital excess, that cash to founders, early-stage executives and other key employees has matched regular market compensation (still with the upside of the equity), this is not true in the vast majority in the start-up game.

In my line of work, consulting to a range of startups as CFO, mentor, COO, counselor and therapist, I come across many "opportunities" to work for equity only and I have a couple of current clients where I do just that. In both cases these are pre-funding companies I believe I can help and where I believe in what they do and how they do it. In both cases the founders pay themselves nothing in cash, and what little money they do have goes to other resources they need to get to a funding milestone.

These are fair arrangements I enter with my eyes open and - particularly in my role - its clear very quickly whether this is equitable or not. Compensation-wise the biggest challenge is insuring people are respectful of my time and skills (when they don't write real checks for hourly or project work they don't tend to be quite as diligent on this as one would like!).

Then you find the people who just don't get it. Recently I was offered the opportunity to help a company and the opening gambit from the CEO was "well, we can only pay equity and in your own blog you say that's OK". Er, yes, but when it turns out that you have a staff of 15, all on salaries, a $3.5m a year burn rate and your equity is worthless due to numerous recapitalizations and bridge loans from investors then either you don't get it or I'm stupid to do it.

The second example came along just this morning. Someone in my network forwarded an email to me from a recruiting firm that is quite active in the Valley. They are looking for a "a stellar CFO to be their financial lead as they build their foundation and move into fast growth" and it goes on to describe all the usual stuff about how you need to know how to scale tall buildings in a single leap and conjure up millions for the business while providing the adult supervision.

Then come the red flags: "you can be an integral person as they raise a C-round of financing" and "we're also looking for someone with the ability to work for equity in lieu of a paycheck at first". Translation: "we've blown through two rounds of funding already and we need to try and convince some sucker to work for nothing and pull our asses out of the fire".

Worse yet, the same recruiter, on their website, is posting a position for "a strong, confident and very savvy executive assistant to support the CEO" and for which they will pay $80,000 a year. The company description makes it crystal clear that this is for the VERY SAME STARTUP looking to pay nothing to the sucker CFO. What kind of client is this that has blown through the money, wants a top-notch CFO for equity only and actually thinks its OK to waste $80k a year on an executive assistant to the CEO? Hello startup, exec assistants to CEO's are out of the question, let alone for $80k! Looks like you should have hired a CFO a long time ago!

Don't get me wrong. Working for equity only is a perfectly valid way to go. But get it right:

• Make sure the arrangements are fair and equitable to all. Don't be paying yourself or others a decent salary and then expect someone else just to work for stock
• Don't mislead someone about the value of the equity. If you have $30m of preference in some manner stuck in front of the Common, then convince yourself of the value of the equity before you try and convince someone else.
• Be respectful of people's time and skills and make adjustments to the arrangement if it's no longer in balance (either way)

Good luck on that Series C raise, by the way!

Things Are Looking Up!

Well, I've been taking a little breather from the blog for a few weeks and now it's time to get back in the swing of things!

One reason for the breather - in the last few weeks things have become incredibly busy! While that's good news for me personally after such a quiet year so far, I think it's even more encouraging for the startup community as a whole.

I think we should be encouraged by the apparent stabilization in the business environment, even though problems still abound. It's clear there is improving sentiment and higher confidence and it's showing even for early stage companies. Some examples I'm seeing (I have to avoid using names due to the confidential nature of the information and the fact that I do work for each of the companies mentioned):

• One company is finding significant new interest in it's voice solutions including from a major service provider in Asia
• A software company is engaged in a new customer opportunity that - alone - could increase it's bookings this year by 50%
• A third received a favourable mention in a major trade publication and as a result is getting significant interest from big-name advertisers for opportunities in it's social network
• A fourth just closed it's first revenue deals after launching many trials earlier this year
• A fifth is accelerating it's efforts to ramp up business here in the U.S. on top of it's European successes
• I've just been approached by a company looking for help in evaluating multiple possible acquisition offers

I could not say any of this earlier this year. And it's both refreshing and welcome to be saying it now! Unfortunately this has not yet translated into closing of new funding for these companies - but you know that this kind of progress will get VC attention sooner or later.

Tranched Investments Are Bad for You!

I've heard a few people talking recently about taking larger sums of money - lets say $3m - from an equity investor where the investor is proposing to tranche the investment (or where the entrepreneur thinks they might). Typically that means meeting certain milestones to trigger the next chunk of cash. I hate this idea. Why?

• Well, first of all the investor can be sending you a negative message about their confidence in you and your ability to execute by holding the money. And its distracting to everyone - you should be working with your investors closely anyway to get the right things to happen in the business and that's the real objective.
• Secondly, things change rapidly in the startup business and you need to change with them - so a milestone set today to be achieved in six months may be obsolete in three months because of some external event. Then what? Keep driving for it so you get the money? I don't think so.
• Thirdly, a VC could decide at any time not to put the additional money in. Lets say they committed the tranches before the recent market crash. Then with the crash their outlook has changed and investment plans rethought. Now they say they won't put in the next tranche even though you hit the milestones. Maybe they want to renegotiate the valuation down due to those external events. What do you do? Sue them? Again, I don't think so. Suing investors is never a good idea if you want to raise money in the Valley again.
• Worst of all, what's really happening is that the achievement of these milestones is in fact increasing the value of the company each time, but your investor's equity is all valued at the historical date when you signed the term sheet. So you just took more dilution than you would have if you took two smaller rounds of funding - one at the beginning and one new one later after achieving the growth.

What do you do instead? Well, you bite the bullet and take less now and plan on doing another, separate, raise later. With that $3m example above, take $1m or $1.5m now and raise more at a (hopefully) higher valuation in a year.

Back in March I wrote in a post that I didn't think financing a startup with debt rather than equity makes any sense unless its to bridge to an equity event you have a high confidence level will happen. Otherwise you just build a pier to deeper water.

In general I stick by that. But there is an exception (every rule needs one!) that I support. In a very early stage startup it can make sense to take initial money, perhaps $300k, from an investor in the form of a convertible note instead of equity at that time. A convertible note is a loan from an investor that is intended to get you going and to bridge to a later equity funding event. As part of the terms the investor can convert the note to equity at a discount, maybe 20%, to the subsequent round preferred stock price. Fair enough - they took the risk now to invest at that later valuation so they should get that break.

When would you do this? Typically, where you need some cash in to get to some proof point or milestone to then get a full equity round done. Your investor likes you and your ideas, but you have no customer traction yet although you're going into beta with a few prospects. You need six months to complete that process and covert the betas into paying, reference accounts. That is a big step because it gives your first real proof points of your value proposition - and makes you more fundable.

In this case maybe the $300k is sufficient to get you to a $1.8m equity raise (including the note converting) in a full funding round later at a $3m pre-money valuation. That's better than taking a $300k equity raise now at a $1.2m valuation and then another $1.5m at a $3m valuation later. A convertible note helps do that with less dilution. One other thing - it avoids the need to address valuation questions today. The company will be valued at the time you get a term sheet for the future round in six months. Its much harder to do two equity rounds six months apart and justify an good increase in valuation over that time. So delay that discussion with a convertible note! An investor will like it because it gives them more protection than equity, it's a smaller amount to risk initially, but gets you going and maybe proves their confidence in the overall opportunity.Of course, if you don't achieve your goal you will owe the money back - but with no ability to pay it off it will become another negotiation anyway.

New Dynamics Emerging in Early Stage Funding ...

Start-ups have been through a dreadfully dry funding period over the last 9 months or so as VC's, angels and other investors have retrenched following the financial market collapse. It does seem as if there is a thaw starting to happen now, driven by an improvement in exit prospects (IPO or M&A) and a returning confidence now that we appear to have avoided a second great depression. And frankly there are some very interesting ideas out there like UsTrendy, a start-up with which I'm working, that in a slowly normalizing market deserve funding to drive to the next level. So what's happening out there now?

We know valuations are down - maybe half of what they would have been a year or more ago, even for start-ups that have made good business progress over that timeframe. While no-one likes a down round, if you raised money a year ago just be happy that you sold less of the company then than you would now to raise the same amount - and that hopefully the cash kept you in business during this downturn. 

However now we're also seeing the amounts raised go down as well. In fact your traditional Series A round is now looking more like a seed funding - perhaps a $0.5m to $2.0m raise versus the more traditional $2m to $6m. Despite valuations being down this is also translating into selling less of the company in the fundraising - maybe 20% to 40% versus 30% to 50%. The reality of many start-ups today is that they can do a lot with less money anyway. People are cheaper, and with the tools, technologies and techniques available today (eg: building cloud-based apps as opposed to complex software applications from scratch) developing the business is faster and a lot less expensive that it used to be.

What we see now is a class of micro-VC's emerging and filling the space occupied previously by angel investors, along with larger VC's getting in earlier with smaller amounts. In the micro-VC class are funds like Come Lague's $20m Nueva Ventures, Fruition Ventures, Capybara Ventures and all the way up to the new Andreessen-Horowitz fund which with $300m is not micro in size but many of the deals, in which they plan to invest from $50,000 and up, are definitely at the seed/early stage. New firms like Javelin Venture Partners, with two partners and a $75m fund are also emerging. Meanwhile established firms like Matrix Partners just closed a new fund in part focused on new seed/early stage investments (this is a marked shift from their typically bigger, later-stage investments) and Draper Fisher with a $7m (miniscule for them) seed stage fund focused on Plug and Play TechCenter startups. 

The reality for VC's is that their limited partners put money in their hands to invest and get better-than-average returns (around 20% per annum as noted in my recent post) for higher-than-average risk. VC's don't accomplish that by sitting on their hands. If anything, logic says the dynamics of great ideas, cheaper costs of execution and lower valuations should be encouraging more investment right now. And I think this trend of micro-VC with micro-investments in micro-startups is going to be the key funding growth area for the future in terms of number of deals being done. That said, there is also a good argument to say don't raise any true VC money if you can get where you need to go with friends and family, angels and a little seed money.

Which brings up the next question - as an entrepreneur, what kind of terms do you want/expect to get for this species of money these days? See my next blog shortly!

The Case for Optimism - Plug and Play in BusinessWeek

For the last four months or so I've been working out of the Plug and Play Tech facility in Sunnyvale as an Executive-in-Residence. Not quite the same thing as the EIRs at venture capital firms who are typically executives of prior portfolio companies looking for their next portfolio company gig, and paid by the VC in the meantime. At Plug and Play I pay rent and get no salary - but I do get a great opportunity to develop relationships with many of the 200 or so start-ups based there, leading to potential consulting, interim or advisory roles, and perhaps the next full-time situation. Oh yes - and i have to pay Plug and Play a cut on any consulting with these companies. Costly? Yes. Worth it? Yes. Great place to be; very interesting opportunities and the chance to help companies who really need it. Good blog material too!

One thing I like about Plug and Play - it is a hotbed of optimism. Everyone here - even though struggling to raise cash and find customers in the current environment - is pursuing a vision or a dream and doing whatever they can to make it happen. You have to like the energy and drive and some of the ideas are terrific.

This week BusinessWeek has published a whole series of articles titled "The Case for Optimism" and Plug and Play is prominently featured in the segment "Keeping the Faith in Silicon Valley". Nice article with a good profile of Saeed Amidi, the founder of Plug and Play. The business is his brainchild and is primarily successful in its mission as a result of his energy, vision and networking. And its a lot of fun to be there and part of it.

Portfolio Returns - What VC's Are Looking For ...

Fund raising by VC's has been a difficult task recently, as we know. Which prompted me to do a little research on what expectations limited partners (the investors in the VC funds) have for their money. I'm indebted to views shared by Susan Mason at Onset Ventures at the SVASE event a couple of weeks ago, and Fred Wilson's blog, A VC, earlier this year (Fred is a partner at Union Square Ventures, an investor in Twitter and some other very interesting companies and one of the smartest investors out there)

In order to raise money VC's have to offer superior returns versus the investment alternatives for their limited partners. We know VC investing is risky and for a limited partner the money is in there for a long period of time (no, they can't pull it out when the market crashes or other misfortunes occur). So those returns need to be quite substantial to attract the billions that flow into this kind of investment vehicle and then have to wait it out.

As it turns out the returns needed are in the order of 20% per annum over the life of an investment in a specific fund - after the VC's get their cut in management fees and their "carry" (share of the portfolio). Put another way, over a typical fund life this turns out to be about 2.5x their original investment. If you invested $10m in a VC fund it would deliver $25m in returns (after the VC fees and carry) when the fund is liquidated after 10 years. Not shabby - if it happens.

On the VC side, then, how do the individual investments need to perform in a portfolio to deliver this kind of return? As an early stage investor Fred Wilson expects to lose all his money on 1/3 of his investments, get his money back or a little more on another 1/3 and make all of the fund returns on the remaining 1/3. Which means the latter have to do really well - about 7.5x the amount invested.
This in fact will range from maybe 2x to 15x per "successful" investment, but you get the picture. 

So in a $250m portfolio of maybe 25 investments, roughly 8 would have zero returns, another 8 might return $80 - $100m in total, and the remaining 9 would have to generate roughly $650m which would come in the range from $15m to $150m. That is not an insubstantial task. But then VC's are highly incented to make it happen!

Of course a VC takes a portfolio approach. An entrepreneur can't. So while a VC can be OK with doing well on one of every three investments, you as an individual need to make the one you're working on defy the odds stacked against you.

Life Returning to the Tech IPO Market?

In my blog on July 9th I talked about the recent survey focused on what worries VC's the most. Given that the answer, overwhelmingly, was "exits" (or rather, lack of them) its interesting to look at what's happened in the one month since my post.

In that period NASDAQ, the broadest indicator of tech market health, has gone from 1,756 to 1,992, or back to early October 2008 levels. That's an increase of 13% in one month. More focused tech indexes have done even better. Just as importantly it continues an improvement in the markets starting back in early March - NASDAQ bottomed at 1,268 and is now up 57% since then.

There are a surprising number of tech companies that are substantial, fast-growing, profitable (or on their way to being) yet are still private. You can see them in numerous tech segments - equipment, internet, software etc. These are the ones that need to spring loose in the public markets and now is the time to start seeing some of them do it. Filing an IPO this month means a good chance of completing the process before the holiday season and hopefully taking advantage of recent market strength.

And its starting to happen. Today, Fortinet filed their S-1. (An S-1 is the basic IPO prospectus or offering document filed with the SEC at the start of the IPO process.) They're a manufacturer of network security appliances (an "appliance" in this context is a simple, server-type box where the core functionality is in the software rather than the hardware - the hardware is simply the container, if you will) that reported over $200m in revenues last year, up about 25% over the prior year, and was slightly profitable. This is the type of low risk, solid, easy to digest IPO that will do well in this market.

Also last week Ancestry.com, an internet company, filed it's S-1. Their mission is to "help everyone discover, preserve and share their family history". Now I'm one of those sceptics who wonders how this can possibly be a big business. Apparently I'm wrong because it did $197m in revenues last year - up from $166m the year before! They're not a Valley company, and in fact they've been around in some form or another for 20 years, but they are an interesting filing to follow as an internet play.

Two other tech IPO's priced (that is, they completed the IPO process) in the U.S. last week - Avago, the Singapore-based former semiconductor group of Avaya, the HP spin off some years ago, and CDC software our of Hong Kong. Both are substantial, particularly Avago with $1.7Bn in sales last year.

More importantly, for our purposes, I hope these are the first of the next wave of tech-related IPO's that will provide exits (or will develop warchests to acquire some of the promising start-ups out there), and therefore hope for future liquidity events from today's investments, and slowly increase the confidence in funding some of the good ideas out there.

Valley Update - Funding, Capital Efficiency, Planning and Areas of Investor Interest

Spent the evening yesterday at SVASE's "Raising Capital for Early-Stage Technology Startups" event and I thought it would be worth sharing some of the thoughts from the three panelists who shared some great insights! They were

• Susan Mason, General Partner, ONSET Ventures
• Matthew Price, Sr. Associate, Nth Power
• Carol Sands, Founder & Managing Member, The Angels’ Forum and The Halo Fund

In no particular order, some of the key takeaways - all of which make great sense:

• "Capital efficiency" is paramount in this market. Meaning that the less cash you have to raise to get to breakeven/cash flow positive the better it is for investors, founders, management and employees. And therefore the cash you have also needs to be managed in the most effective manner possible.
• Yes, lots of portfolio companies have been through significant restructurings and downsizings to make the cash last and become more capital efficient. In many cases this has been a great thing as it has forced people to look at their businesses much more critically. This has been very timely as we've seen startups finding the external market has caused them to fall 6 - 9 months behind on their plans, though many are now getting back on plan.
• There will be a big shakeout in the VC business, in particular with those who have not raised additional funds or capital in the last 2 - 3 years (to be clear, all the above HAVE raised capital and are not in this situation!). The ripple effect on their portfolio companies will be substantial and ugly.
• We're seeing a return to real "sweat equity" with startups - which is a good thing!
• Good VC firms are still investing. Many are also looking much harder at how that equity gets leveraged or enhanced - partnerships, channels, even grant and government monies (which Silicon Valley companies have traditionally ignored but I see many European companies pursuing quite successfully)
• Silicon Valley startups have also not traditionally sold to the government - rethink that!
• Your financial plan needs to assume that not everything goes perfectly. In fact it needs to presume that many things will not go according to plan. Therefore always take as much money as you can now because you never know. Your financial plan is not just about having gas in the tank, but about "de-risking" the business. When you have cash you have options and can manage things going wrong. When you don't you have no options. None.
• If you're very early stage look at pre-seed convertible loans and other creative financing strategies - a bridge loan to a syndicated financing round etc (but as I've said before, make sure its a bridge, not a pier!). Get your suppliers and customers to help finance the business. 

Susan Mason, particularly, also did a great job of pointing out some market areas and opportunities she thinks are very interesting for investors:

• Monetizing data real-time
• "Everything" as a service - SAAS, Cloud Computing, PAAS, etc
• Enterprise 3.0 - for example, free, ad-supported network management tools
• Security as a service
• Financial payments infrastructure
• Internet gambling - when it becomes (inevitably) legalized here as it is in many other countries
• Virtual goods-based companies
• Mesh sensor networks with recurring revenue models
• Medical devices that speed up diagnostics or provide custom or personal medical solutions via your genetics

Pitching to Prospective Investors ... Part 3

In previous posts I've listed some of the things that start-ups should focus on - and things they should avoid - to give themselves the best chance of success when pitching to a prospective investor.

Some are critical - doing a well-rehearsed demo for example. A start-up I saw pitch recently - UserZoom out of Spain - had a very well done video clip demo included in their presentation. This meant the pitch man Alfonso de la Nuez, their VP Marketing, was able to focus on explaining what was going on and how it works rather than fumbling around trying to connect and make it work and he was able to move quickly enough to get the desired effect. Kudos to him - it worked brilliantly!

After observing more funding pitches I notice a substantial issue for many is the one of communication, specifically when English not the primary language of the person pitching.

I saw this with at least 3 different start-ups just last week. Two of the three had great stories. One was an Italian software company looking to start up it's U.S. operations and potentially establish it's headquarters here. The other was a start-up with a Vietnamese cofounder that has developed a explosive detection system. The U.S. Navy has funded 3 prototypes to date. (The third, an Austrian company, had such a badly-flawed strategy for a new password-replacement system that the language issue - and it was there at a low level - rapidly became a non-problem anyway!).

To be perfectly clear, this is not a bias issue. Not even for a Brit used to hearing the Queen's English butchered on a daily basis. It's about getting the message across clearly and concisely in the limited amount of time you have in front of the prospective investor.

Now, most investors are patient and will try hard to make sure they get it. But if you struggle with the English language then find a way to communicate that relies less on you talking and more on the demo, on the slides and so on. Bring a team member who is fluent and can fill in the gaps (NOT a translator, a bona fide member of the management team). The demo approach taken by UserZoom is a great example of a way to solve the problem (in that case the English was perfect, but had it not been then this approach would have helped address that superbly).

It's hard enough to raise money these days. You need to insure that the pitch literally "speaks for itself"!

Yet More on the State of VC Funding ...

I hate to keep harping on VC funding, yet its still the lubricant the Valley relies on to help turn ideas into substantial businesses. The market is crying out for alternatives but for now its still the main game in town.

Because my focus is on Silicon Valley itself - more broadly, technology in the greater San Francisco Bay Area (so, yes, including San Francisco's South of Market start-ups, Emeryville and so on) - I'm always interested to see how the money flows to the Valley compared to other geographies. Here's Q2 2009 VC funding of start-ups by region, courtesy of Silicon Alley Insider (as are the other charts in this post)

The Valley continues to be the main recipient of VC funding, with one third of the total. Frankly, I'd expected it to be more. You can certainly see how the rest of the market is very fragmented, geographically.

In Q2 the industry segments that did best were biotech and medical devices, whereas clean tech has collapsed from a funding perspective (the Industrial/Energy vertical below). No real surprise as energy prices are way below those of a year ago and its still a tough space to figure out winners and one that requires substantial capital resources for success.



In a recent post I talked about VC's main concerns around lack of exits, or ability to eventually find a liquidity event that actually realizes their investment. Here's a very graphic representation of the (lack of) IPO opportunities for liquidity. The chart doesn't include Q2 2009 in which I think there were 3 tech IPO's including OpenTable, but its still a collapse compared to the couple of prior years. It won't continue this way for ever and in my next post I'll suggest some reasons why ...

Three Keys to Startup Success ... Monetization Strategy, Effective Marketing and Management

Three things keep showing up as critical to getting a startup on the road to success - Monetization Strategy, Effective Marketing, and Management. Ok, yes, cash helps too. But you won't get cash without being clear how you'll use it to execute well in these areas. A good, working product or service? Of course - but history is littered with great ideas and good products that never went anywhere because people didn't know how to turn then into successful businesses.

Success in the near term may be getting enough funding to enable the next stage of a company's development. This may be completion of the initial product, build out of the team or gaining initial marketplace traction. In the long term it's building a sustainable, profitable, growing business with a large market opportunity (unless you're building a lifestyle business - which looks a more and more attractive option these days!). So what do I mean with these three things that are so critical to getting on that road to success?

Monetization Strategy

As I've noted before, with certain exceptions (Twitter, at least for now; YouTube - though not for much longer), having a clear, well thought out and tested monetization strategy is critical. "Tested" ideally means people paying real money for your product or service and who will be reference accounts (ones that a VC can call and talk to) - or, if you're still very early, credible people who will say "yes, if you produce that I'd buy it and here's what I'd pay". Its highly unlikely you're going to be a trailblazer in your monetization strategy. Leave that to Google, Salesforce and others. But you ought to know what others are doing and how you play off key trends and examples in the marketplace - term software licenses instead of perpetual, scalable subscription-based services rather than fixed fee, micropayments (many  payments of small amounts) and so on. See my post from May 8th for more!

Effective Marketing

For many of the startups I've seen pitch this year the biggest near-term challenge is getting known and then getting customer traction in the market. "Who are you and why should I care?" is a major barrier - but when you solve it you are in great shape! In a pitch I saw last week from a very exciting startup, UserZoom, being able to say you have eBay, Monster, Shell, Novartis and others as paying, happy customers in less than a year from starting their service is the most compelling thing you can have when raising money. Fortunately these days the options for creative and cost-effective marketing targeted at getting that initial adoption are better than ever. See my post from April 11th for more on marketing spend - what's worth it and what's not. 

Management

Although it's an old axiom in the VC business - that VC's invest in management teams - it rings even more true today when money is scarce. Why? Because VC's know that great management teams are far more likely to execute effectively, with fewer mistakes, and find ways to turn good ideas into successful businesses with the least amount of cash investment and lowest risk. The VC money is the lubricant - but its people who have to make it happen. Regrettably, many inexperienced founders have a hard time understanding that the best thing they can do is hire people who have been there, done that - but that's what it takes and what a VC will look for. Find and hire the best people you can to help turn your idea into reality - these days those people are even more readily available than ever before.

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VC fundraising - it just keeps getting worse ...

Q1 (January through March this year) was bad for VC's raising money for new venture funds, coming as it did right after the implosion of the financial markets and the screeching halt to IPOs. New numbers from Thomsons and the National Venture Capital Associaton show that Q2 (the three months through June) was even worse. Check it out:

Note the average size of fund raised. In Q2 this was barely $70m per fund. That's pretty small compared to an average of almost $150m in Q4 2007. Is that a problem? It can be - smaller funds typically invest in early stages (good for startups) but aren't able to participate in larger rounds of funding for later stage growth. Where will that money come from?

Let's also be be clear what this money represents. Money they raise for their funds in Q2 is not the money VC's are putting to work today  - that money comes primarily from funds raised in prior quarters and years. This is the money they raise today that they will have available for future investments over the next few years. Not a good omen as startups look to raise money for their future operations.

VC's will normally invest money in new portfolio opportunities for the first few years of a fund's life. They typically keep some portion of the fund available for follow-on investments with the companies they have already financed from that same fund - in part to maintain their ownership but also to insure their portfolio companies make it to an exit. Given that the latter is taking longer these days, they need to keep more of that powder dry than before. What this means is that once the monies raised from, say, 2006 through 2008 have been put to work or earmarked to support existing investments, there will be a drought for new startups. Of course, startups are feeling a drought now as, with the lack of exits (see my last post), investors don't even want to put that prior money to work.

Is it all doom and gloom? Not exactly. While August Capital and other premier names in the business continue to close new funds, and top notch individuals like Marc Andreessen and Ben Horowitz with their new $300m fund can still do whatever they want, this will weed out some of the weaker VC firms that, frankly, probably shouldn't have been in the business anyway.

And to get your startup funded you have to focus on the things that were always important but tend to be forgotten in times of plenty - great ideas, solid execution, hard work, superior management teams, monetization, creative thrift with spending ... qualities which are still in abundance in the Valley!

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Is Your Financial Model Ready to Meet Your (Prospective) Investors?

As I work with some of the startups here in the Valley looking for early-stage funding, one of the weak spots in their approach to investors is the financial model they've developed. Or - in some cases - not developed.

No matter how exciting the idea, how great the buzz or how wonderful the management team, your pitch to investors has to show how you will build a business that will be big (if it won't be big then it won't be attractive as an investment now), and will generate profits. This is not slapping together a few numbers and hoping for the best. The financial model you develop needs to show that you know how you'll monetize the idea (generate revenues) and what resources it takes to develop a robust product or service, generate customer awareness, close deals, get the customer up and running, keep them happy and scale up the business. Most importantly, it will tell an investor just how far the cash they are putting in will go - and it had better be far enough to give the company a strong shot at getting to the next fundable stage.

To explain how all this works, how to put together a compelling model and what to look out for in the process I've been presenting a workshop to CEO's of early stage companies. Here's the how I define the process for developing the model:

The last part - validating the model - is often overlooked by early stage companies. If you really think you'll be bigger and more profitable than, say, Salesforce.com or Google was after 4 years then by all means say so. But for mere mortals in business you probably want to set goals that are a little more realistic and then explain to your prospective investors how this compares to where the other companies were at similar stages in the past.

Hint: if those "comps" are now public companies you can go to their SEC filings and type in "S-1" (without the quotes) in "Filing Type" and you'll find 3 - 5 years of financial history prior to their IPO. Often this takes you back far enough to see a few years that will overlap with your model. Here's the S-1 filing for Salesforce from late 2003, with data going back to their inception in 1999 (page 23)

Here are some of my tips for success with your model:

To get a copy of my full presentation please download a .pdf of the materials. By the way, the orientation of this pitch is towards the companies I primarily work with - internet, ecommerce, software and related companies. A fabless semi company or a telecom equipment company will have, by necessity, a more complex model but the principles still apply ...

Download Startup Financial Models - Philip Smith

If you have any questions or comments, want me to come explain this to you - or just need some help - please let me know!

What VC's Are Most Worried About ...

Not only did VC investment in startups fall again in Q2 this year (the 3 months ending June 30) compared to Q2 2008 (by 57% from $6.5 Bn to $2.8 Bn) but in a survey by Polachi Inc just published on Silicon Alley Insider the reason why is not what you might think.

It's not because they can't find good investment opportunities - fundable ideas, if you will. From my own experience and that of others I talk to in the investment community the "deal flow" of good opportunities is stronger now than ever.

It's not because they can't invest in decent management teams. If anything the recession has thrown a lot of talent into the street that is a goldmine for startups looking to recruit  the skills and build teams.

It's not because of a bunch of other things either. Its because the VC's don't see an "exit". A successful exit - for a VC - is simply an IPO (take the company public and sell your shares for a 10x or greater return on your investment 6 months to a year after the liquidity event) or a sale of the company to a corporate or other acquirer (Google buying YouTube, EBay buying PayPal etc). As we know - with few exceptions such as the recent OpenTable IPO - the IPO market has been dead. And the corporate M&A market, despite the attractiveness of some of the acquisition opportunities (lower valuations, lack of other exits etc), hasn't been much better.

So the biggest issue stopping a VC investing today is "how will I actually realize the return on my investment in this great idea?" If we don't solve that problem then we are in for a rough time getting Valley startups funded - which will be to the detriment of the whole ecosystem and technology in general.

(And no, I don't know why it adds to more than 100% - I guess some people are "most" worried about more than one thing ...!)

Pitching to Prospective Investors ... Part 2

At the end of March I posted a blog outlining some key considerations in pitching to prospective venture capital investors. This was not the usual pitch content stuff - more on demonstrating, listening and interacting with your target audience. After another couple of months of seeing and hearing pitches I'd add a few more observations:

First, be realistic about the current (mid-2009) funding environment. Frankly, if you raised money a year or so ago at, say, a $4m valuation of the business then EVEN THOUGH YOU'VE MADE GOOD PROGRESS SINCE you should prepare to accept a lower valuation today for new money. That's the reality of the market. Look at it this way - the money you took earlier just happened to be very cheap, by both historical startup standards and by those of today. Today is hard - but more normal than you want to think!

Second, as a corollary to the first point, take only the money you really need to get to complete the next key business milestones for a further round later. Don't go in and say you need $5m if - with diligent focus and execution - you can deliver major progress in 12 to 18 months with $2m. Not only will you not get $5m but you'll look naive - and you'll have a better shot at raising additional money later at a hopefully higher valuation.

Third - demo time again. Do it, but for crying out loud, make sure it works ... no fumbling, no passwords, no glitches. If you have set up to do, arrive early, set up and test it before the investor steps into the room.

Fourth, don't bring a whole team unless each person has a key role in the pitch or reason to be there. In a few pitches recently there have been 5 or 6 folks from the startup - and only one does any talking. What's the point? To show you have a bunch of deaf mutes on the team? On the other hand, don't do a pitch where you're constantly tag teaming on every single slide. The CEO should pitch - anyone else chimes in only with a few carefully orchestrated points or slides (eg: the CFO presents the financial slides). 

Fifth, management is a key factor - even more so today (and as I say above the whole team does not have to be present in the pitch - the investor will get to meet them later). Do you have a team who can pull it off? If the investor asks about your background, have the relevant info ready to spout. Relevant meaning as in how you're qualified to be entrusted with this money and proven capable of pulling it off. If you can't remember the basics of why you're the guy, then why would you get money?

OpenTable IPO's - Signs of Life?

Image by arvindgrover via Flickr

OpenTable! Its not exactly a major technology play - though it is a service I use for almost all of my own restaurant reservations. But it is a venture-backed, Silicon Valley-based startup and potential bellwether for the state of the IPO market as a whole.

Its no secret that the IPO market has been dead in the water for some time, with just 3 companies going public in the last two quarters compared to an average of 61 each quarter in the prior 3 years. With OpenTable and SolarWinds both IPO'ing this week that's a total of 7 companies so far this quarter. 

More promising than an uptick in the number of IPO's is the initial performance of these two companies in the market. OpenTable's stock was up 59% on its first day, although shedding some of those gains by the end of the week. SolarWinds was up 10% on it's first day but ended the week a little below it's initial offering price.

May sound odd to suggest that its still a promising sign when a company trades slightly below its offering price but my rationale is that it suggests the IPO was well priced by the underwriters whereas the jump in the OpenTable price is an indicator that the underwriters of that deal in fact priced the shares too cheaply. Not to digress too much but the whole point of an IPO is to provide liquidity for the company and its existing investors - and they get whatever the offering price was, not whatever it trades at afterwards. Interesting to note that 3 institutional investors in OpenTable sold shares at the IPO. Usually an underwriter doesn't like this and typically even locks in investors, employees and management to an agreement not to sell stock for six months after the IPO (a "lock-up" agreement), the rationale being that investors selling at an IPO indicates lack of confidence in the business whose shares are being sold at IPO to other investors. In this case, my guess is that these investors desperately needed the earlier liquidity for other reasons than lack of confidence in the company - but now it looks like they also left money on the (open)table!

Given the traditional importance of IPO's as a key liquidity objective of Silicon Valley companies and investors and in the overall ecosystem of the Valley, some signs of life I hope! Will be interesting to see if other companies are now encouraged to follow suit ...

State of the Market - Venture Capital Funding

PriceWaterhouse Coopers recently released their first quarter 2009 MoneyTree survey of venture capital investing. Not a pretty sight, as we'd all expected. In fact, with a total of $3.0Bn raised, it was the lowest quarter for funding since 1997 (a year that was then rapidly eclipsed in the inflation of the dot.com bubble)

However there are some - including the experts from PWC - who think that this is likely to represent the low point of 2009 as VC's and startups adapt to the new market realities and get things back on track, however modestly.

I think the main lessons from Q1 are:

• Investors have retrenched and refocused, and are being far more discriminating about what they're funding and why. No surprise there!
• Software and Internet-related businesses tend to be even more favoured (less disfavoured?) in hard times - they are less capital intensive, require far less money than some to get to be self sufficient (ie: less need to find additional monies later), and carry far less risk for an investor.
• Despite all the declines its still better to be a seed or early stage startup looking for money than someone looking for expansion or growth funding. Might seem a little counterintuitive but good ideas are still getting funded and investors are willing to take some chances there and with later stage businesses with proven records. But if you're in the middle - still trying to grow and prove the business is scalable etc then you really have your work cut out.

Here are some of the key data. By market sector:

• Software funding totaled $614m - a drop of 42% compared to Q4 2008. 138 companies received funding.
• Internet-related companies raised $556m for 123 deals, a 31% decrease in dollar terms. Funding sizes were also smaller on average.
• Life Sciences investments were down 40% with $989m going into 133 companies.
• Clean Tech in general took a big hit - an 84% decline to $154m
• Telecoms (down 72%), Networking and Equipment (down 47%) and Media/Entertainment (down 45% were all badly hit
• Surprisingly, Financial Services actually showed a funding increase - up 26% with $108m invested. Of course the fourth quarter would have been pretty bad for that sector!

Life sciences fundings tend to be larger due to the longer time horizons for product development and the greater capital required than for software. Clean Tech is not only highly capital intensive but the decline in oil prices and overcapacity in some sectors (solar panels for example) is causing a further pullback in investment. Telecoms and Networking tend to be capital intensive and have longer development cycles, and therefore less in favour with investors from a risk-management perspective. Media - really advertising and related plays - continue to be out of favour as that sector consolidates and retrenches .

By stage of development:

• Seed and early stage investments were down 45% to $852m, and average deal size was $3.6m for seed and $4.3m for early stage (pre-Series A). These accounted for 37% of total financing in the quarter
• Expansion stage financings declined a whopping 60% to $820m and average deal size also declined substantially - from $7.5m to $5.6m - and contributed 27% of deals done
• Later stage deals fell 35% to $1.3Bn and average deal size also declined from $8.1m to $6.7m

First-time financings - regardless of stage dropped 48% to $596m and comprised 20% of the total dollars invested. Software companies were among the bigger recipients and seed/early stage companies received 59% of all the first-time money and accounted for 70% of the number of deals.

What's Your Monetization Strategy?

Image by ZeroOne via Flickr

In talking with venture capital firms and with the startups that pitch to them there are many key areas to emphasize in a business plan. I'll be posting about some of these over the next few weeks.

One such area, however, is your "Monetization Strategy". At various times in the recent past - coinciding with the formation of a bubble or pending market bust - investors have not cared about this. It was all about "eyeballs" or "land-grabs" or whatever the then-fashionable euphemism for forgetting about how to be a business person and real investor. Fortunately - with a few exceptions such as Twitter (where it will still come) - investors and business people have returned to basics and now want to know "how will you turn this idea into something someone will pay for, and what will be the resulting revenue stream?"

However it can be very complex if, say, you're a software company or a web-based services company. Your software licensing model may be the traditional (a.k.a. outdated) expensive perpetual licence and annual software maintenance contracts. A perpetual licence gives the buyer the right to use the software in perpetuity but you'll need to pay 20% or so of the original license fee per year to the seller to access support, get upgrades, bug fixes etc (ie: to insure it still works).

These days its highly unlikely - impossible, really - that you'll get funding (or market traction, come to that) for a startup software company with a perpetual license monetization strategy. In part that's because there are far better alternatives - for customers, investors and for you. Term licenses bundled with maintenance in essence take a software rental approach. You still take "delivery" of the software and have to install it at your site; however you use the software for a defined period of time for a set fee - or for a variable fee that might be based on number of users, transactons processed or whatever. Obviously you can renew the license when the term is up (though you will not typically guarantee what the price to the customer will be when that happens). A big advantage for an early stage seller is that its typically easier to get the customer to adopt your solution than with a big upfront fee - think of this as the leasing model for a car, vs. a cash purchase.

More common now is an "on-demand" or "software-as-a-service" ("SAAS") delivery and monetization model. The customer doesn't install the software at all. They log into a web-based service you've set up - which can be very customized for them - and they pay by usage, number of seats (individuals in the company using the service, etc). No other license fees, no ongoing "maintenance", underlying software is always up to date (because its completely run and managed by the provider as service on their platform). This is a great model because its easy to understand and sell, it scales from one user to thousands without any changes or upgrades, etc.

Many other monetization models now exist, thanks to the on-line nature of many businesses. Advertising-supported models have become a huge factor, with Google, Yahoo! and others being such major players, and hosts of other companies providing tools, services, channels and so on around this. So much so that there has been major dislocation in all of the previously off-line, ad-reliant businesses - newspapers being an obvious example. 

So what's your monetization model? In my next post I'll consider some of the factors to think about as you develop yours!

Raising Startup Funds in Today's Environment ...

Whether its one guy/gal with an idea or a more developed business ramping up rapidly, one thing they all worry about is cash. Funding. Where - in this environment - is the money coming from to move the idea/product/technology/business to the next stage?

Because I have a track record (I've raised over $80m in venture capital in the last 10 years for a range of startups) - and because I'm a finance guy - founders and execs in startups tend to turn to me for help in figuring this out. Well, there's no magic wand, that's for sure.

Consider the range of traditional funding sources at various stages and what's going on out there. In the rough order from very earliest stage to the later stage funding rounds, here's what its like out there now:

Friends and Family:

These are the traditional backers of the Next Big Thing to help Johnny get it under way. With a group you might raise $100k or so. However my guess is your Mom, best buddies and Uncle Bill have all seen their home values collapse, their 401k's beaten up and their own jobs disappear in the last year. Not a great environment to invest in your latest harebrained idea, really.

Angels:

A traditional Valley source for a few $100k's. However many of these have also seen a big drop in personal wealth. But they are more risk tolerant than Mom, and probably understand the idea and the opportunity a lot better than Uncle Bill. And at least you won't have to face them at the Thanksgiving dinner and explain why there's more than one turkey in the room. Still pretty hard though ...

Alpha, Micro-Cap and Seed Stage VC's:

Better. Collectively, perhaps with Angels, you might still raise up to $1 million or so. Stiff competition for the cash. But they are "risky idea" stage investors and the money is still out there.

Series A Venture Capital:

So your idea has turned into technology and thence into a product/service. And, wonder of wonders, its getting traction in the market. Assuming you've checked all the boxes - team, market opportunity etc etc - then this is still a viable source. Here we're in the $1m - $3m range these days.

Venture Debt and Equipment Leasing:

As I've said before, don't borrow unless its a clear bridge to a next equity funding event. Otherwise its a pier to jumping into much deeper water than you really want. But don't worry, no-one is lending anyway.

Strategic Investors:

These are the big corporations who might invest as much as a few $m for the right opportunity. Still possible these days, particularly with a real strategic partnership. Problem is, in true shortsighted American business knee-jerking, many strategics have pulled way back or have even moved to stop any new investments in this environment. These are the same companies now downsizing or divesting the acquisitions of the last few years in a "change of strategy" because the "market environment has deteriorated rapidly". Don't get me going ....

Series B, Series C etc etc ...

Hard, hard, hard. You'd better have the engine running on all pistons ...

Tough? Yes, of course. But you know what? This is STILL a great time to start a tech business. And there is money out there. But you need to really work hard to earn the right to have it

Pitching to Prospective Investors ...

In the past few weeks I've been sitting in on some funding pitches to angel and venture capital investors by a dozen or so startups. Its pretty interesting to be in this position as I'm usually the one pitching, not the one observing. And its startling to see some of the approaches - some are sophisticated but most are not. Very not! Some observations about how some of these guys could improve their chances - in some cases by a considerable amount!

First, listen to the feedback and questions and don't paint yourself into a corner. For example, one startup focused entirely on a market defined by Novell Groupware. This is rather like saying you're focusing entirely on the market for horse-drawn transport. Yes, you are right, there is no competition. There's a reason why - its not a large and growing market. Its a dying market. But when the prospective investor pushed back and said this  - and that they only focus on large and growing market opportunities - the startup's response was to insist that this was the right strategy and argue the point. When I asked if their solution could be ported to other platforms such as Microsoft's Exchange / Outlook suite they said "absolutely". They would have been far better served to have positioned themselves as addressing the overall market and - if appropriate - prove the concept with Groupware, but as a stepping stone to greatness!

Second, do a demo of the product or service. Its the best ad for what you really do. But make sure it works and works easily. Don't arrive lugging a big screen TV and fumble around trying to set it up while you're presenting. Seems basic - but I just saw it happen! Even if a demo is not in your plan, be ready if the prospective investor asks for it. One startup was so unprepared for this request (it should have been a simple web access to a site) that they couldn't log in because no-one knew the user ID and password! Yikes!

Image by YanivG via Flickr

Third, don't use one of those stupid red laser pointers in a small group setting and don't wave it around all over the place. You're standing right by the screen. People can read. A simple hand gesture gets the point across - not a laser lightshow. You need the investor to focus on your message, not duck to avoid being blinded!

My guess is I'm gonna have a lot more of these stories. Being prepared and properly coached is something that can never be undervalued. Coincidentally I can help with this - but some things are simple common sense, are they not?

Fred Wilson on Venture Capital Returns

As an entrepreneur its always good to know what kind of financial outcome or return your investors are looking for when the put their money in. The better you understand their motivations and dynamics the better you can line up the right investor and have all parties goals in alignment.

Fred Wilson, a partner at Union Square Ventures, gave a good view of this in a post on his "A VC" blog over the weekend. You can read the whole thing here.

At USV, which is an early stage or "seed" investor, Fred's rule of thumb "is "1/3, 1/3, 1/3" which means that we expect to lose our entire investment on 1/3 of our investments, we expect to get our money back (or maybe make a small return) on 1/3 of our investments, and we expect to generate the bulk of our returns on 1/3 of our investments". He then goes on to explain how the returns on that last 1/3 need to average around 7.5x the money they put in to get the returns they and their investors expect on their portfolio. Ideally, they get one big home run - big enough to cover all the money invested in the portfolio - with the other winners generating the overall return. Of course, it depends on a bunch of other factors - size of investment (a 10x return on a $1m investment has a lot less impact than a 5x return on a $10m investment), etc. 

Image via Wikipedia

So in a baseball analogy, you're considered pretty good if you can consistently hit .333 with the occasional home run, triples etc. within that average. Of course, its not cricket, which is a real bat and ball game and where you have to do some substantial scoring or bowling to win. But I digress ...

For an entrepreneur, the problem is that you don't have a portfolio approach you can take. This - your startup now - is it. You have to win. You have to hit the home run in your only at-bat. Being in the bottom 2/3 of the investor portfolio means you lose - your time, your effort and whatever sweat equity (founders stock) you put in. In fact, its a bit worse than that because you'll usually own common stock and the investors will own preferred stock - meaning they will get their money (and sometimes multiples of their money) back first before you see anything (except in an IPO where everyone converts to common at the IPO event). 

Thats the way it is and, as always, he who has the gold makes the rules ...!

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• Fred Wilson: Founder Dilution - How Much Is "Normal"? (via A VC) (avc.com)

Financing Your Startup with Debt - Good or Bad Idea?

Image by DanielaNob via Flickr

If you're an early stage company at some point you may consider financing your business with debt as well as - or instead of - equity.

There is no simple right or wrong answer about taking on debt as, with so many things in startup land, it depends ... on the company's stage of development, the availability of other funding sources, etc.

And as usual with banking, the less you need it the more available it often is.

Over the next few weeks I'll explore some of the factors to consider in looking for and taking on debt in your startup.

However, remember that debt is not like equity and there is a requirement of regular repayment of the principal along with the interest.  At some level its the same as a mortgage on your home - you repay principal and interest monthly (perhaps starting after some months of grace period) and therefore you need to be comfortable that you will have the ability to repay this debt even if the value of your business declines. You therefore need to be very comfortable that the reason to borrow is to use the loan as a bridge to a key event or milestone - a sale of the business, completion of an equity funding round, achievement of consistent positive cash flow in the operations of the business, etc.

I am not a fan of borrowing to generically "extend your runway". Unless you have a clear and achievable goal with a high probability outcome that the debt will bridge you to, then you will have simply created a pier and when you plough into the water you'll be in a lot deeper than when you were dabbing your toes in at the water's edge!

So, Rule #1: Use debt only to build a bridge, not a pier!

Upside of the Downside ....

In San Francisco today for a lunch event with a presentation from Come Lague with Nueva Ventures about raising money for startups in this environment. What struck me is the sense of déjà vu for someone (me) who has been in the Valley for many years.

The market is basically saying that startups have to get back to fundamentals – tangible value propositions, bootstrapping mentality, friends and family funding, work for equity and nominal cash only for a while…. You know, this is how startups used to be 15 – 20 years ago in the Valley. People just seem to have forgotten this in the easy money days of the dot-coms of the late ‘90s and the internet-based social networking boom more recently. No doubt they’ll forget it again in the future, but right now this is where its at.

The good news today is that there are many, many more creative ways to build a business than ever before, and many more tools and resources to available to become successful. And now more people with great skills and talents available to help make it happen – the upside of the downside in the Valley!

Still, cash at some level is a necessary ingredient. I think Come’s firm, as a newer kind of “micro-cap” VC, has an interesting niche to help promising startups bridge between the bootstrap/friends and family/angels stages and getting investments from the bigger VC’s. They invest $100k - $1m or more at an early stage, sufficient to help entrepreneurs prove a concept, get traction in the market and so on before going to the big guys for their funding to then build something big from it.

In passing, one comment made at the lunch … something like, for startups, “the less the CEO is paid the greater the chance of success”. I don’t know if anyone has actually studied this but it’s an interesting assertion. Having a passion for the business and being hungry (not starving, perhaps, but motivated) for success THEN brings the financial reward. Not that I would turn down the big money offer mind you….!!!