5 posts categorized "April 2009"

Signs That Early Stage Investment Models Are Changing

Depending on your point of view, angel investors are either getting more organized, or traditional VCs are moving upstream into angel territory.  Or maybe there are two trends, and the two are converging.

In a post on peHUB yesterday, Connie Loizos reported that two-digital-era Bay Area veteran entrepreneur Noah Doyle is forming an early-stage venture fund, together with an East Coast venture capitalist who cannot yet be named.  Loizos sees the trend as driven by seasoned entrepreneurs; she observes, “while venture firms across Silicon Valley continue to quietly implode, the number of ambitious entrepreneurs trying to create new venture capital firms continues to grow.”  In Seattle, this entrepreneur-led trend is perhaps most prominently exemplified by the Founder’s Co-op.

Paidcontent.org is a good place to find an aggregation of what it calls the “ flurry of announcements from VC funds and entrepreneurs recently of the launch of funds focused on smaller, early-stage bets.”

The Bay Area startup “bootcamp” and seed investor Y Combinator is also now teaming with venture capital firm Sequoia.  On their site, they explain this move as being directly related to the opportunities presented by the depression:

"It's a big step for us to raise outside money. Till now we'd only used our own. But we didn't want to let the bad economy make us conservative. Instead of hunkering down to wait out the recession, we want to expand to take advantage of it."

Interestingly, though, they seem to already acknowledge an inherent tension between their entrepreneur-friendly early stage mission, and the traditional VC imperative to secure participation rights.  Note the following from their Q&A:

"What will Sequoia and the angel investors get in return?  A percentage of the returns from the startups funded with this money.  They will not get a right of first refusal to invest in the startups' future rounds."

That answer would indicate to me that Sequoia must be putting its money in for the early intelligence gathering aspects, and will continue to tend its own seed stage portfolio.

The Invisible Ink is Drying. It Reads: Disruption is Easier to Sell in a Depression

One benefit of the economic depression, just starting to reveal itself, is that some startups are able to skip the early adopters and insinuate themselves with traditional enterprises they had first assumed would take longer to develop as customers.

A handful of startup CEOs I know are scrambling to implement and service big customers who signed on unexpectedly in Q1 ‘09 after shorter than anticipated sales cycles. It would appear that, to bigger enterprises looking to streamline efforts and costs, startups with innovative new solutions are starting to look less like upstarts from the bleeding edge and more like low cost providers.

One CEO, of a b2b company (client), has been travelling nonstop to the Midwest, New York, and London, and is now scheduling trips to China.  Although his venture is less than two years old and represents a bold, new way of executing a key business function in the industry his venture serves, he has in recent weeks found it easier to schedule meetings with executives at large enterprises.  Indeed, Fortune 500 companies are now often first seeking him out.  After discussing this with him by phone last week, I followed up by mail to ask if he could explain the phenomenon.  He wrote back as follows:

“The way to look at this is that in times of difficulty companies will purchase products and services that are critical in the production and revenue generating aspects of their businesses.  For emerging companies to succeed in this climate, they need access to the key decision makers in an organization to understand how they are prioritizing expenditures and where they have identified needs for more efficient methodologies.”

This CEO is in an enviable position:  he and his co-founder have 35+ years combined experience in the industry their venture serves, and their contacts include senior executives they worked for before deciding, two years ago, to start their own company and greenlight their own initiatives.  Door opening may yet be incrementally more difficult for younger entrepreneurs, or entrepreneurs tackling new markets in which they did not cut their teeth.

Another company (client) is in a space that stands to benefit as newspapers die.  The founder and CEO of this company discerns that advertising spending is migrating, not only to online publishers, but to other traditional (non-print) broadcast media. "In fact," the founder and CEO of this company tells me, "advertisers are interviewing [publishers in a particular broadcast media space] to see who is doing more to become interactive." 

He continues, “The current market is searching for enablers, and [Newco] is one. We are definitely better off in the current economy.”  But, he is quick to add, his ability to realize more of the opportunities depends on having “the required financing in place.”  His angel investors continue to support the company, as they forsee that revenues will match expenditures by the summer; but this founder and CEO also knows he will need significant additional capital, not to generate profit, but to scale a company of a size adequate to the opportunities.

Not all startups are mapping trends the same way.  Another CEO of another b2b company (client), in the space of data capture and analysis in a retail industry, agrees that the depression has helped his venture.  In response to mail from me, he writes, unequivocally:

“[We] would not have grown as fast nor realized the wide spread receptivity to our solution without the current economic downturn.  One of the reasons our competitors, who have been in business for several years before we emerged, have not grown fast is that having a [measurement and analytics] product or service was a nice to have and not a need to have. “

“The economic climate forced [industry] operators to look at every aspect of their business.  And the ease of use and comprehensive feature portfolio we offer has made it easier for operators to move forward with a service like ours. “

In subsequent exchanges, however, he clarified that the heightened awareness of his company’s service did not necessarily translate into a shorter sales cycle.  In fact, he perceives that his sales cycle has lengthened.  How could this be, I asked?  His reply:

“The biggest reason the sales cycle has extended is that [industry] operators have historically been very apprehensive about implementing technology.  Therefore, despite the fact that, in theory, implementing a program which will save them big money makes sense, they need to see conclusive financial results from the program in their financial statements.  Most technology products and services which have been marketed to the [name redacted] industry historically have not delivered the financial results they claimed to.  Unfortunately, this precedent forces us to conduct more analysis and leave the system in longer to deliver these results.”

So the good news:  the depression is opening more doors for startups.  The more sobering realities:  while potential customers are now eager to listen, they are yet cautious about expending funds, and may want new solutions to deliver savings first.  Funding implementations, especially at faster rates, is tough, as all emerging companies now face new uncertainties about the price of capital, if not also its availability as needed.

What Happened to the 1x Liquidation Preference?

In a presentation at the MIT Enterprises Forum Venture Lab at One Union Square in Seattle last month, titled “Financing a Start-up in a Downturn,” Andy Sack of the Founder’s Co-op and Michelle Goldberg of Ignition tracked trends in startup financing, and how first round deal terms have changed over the past year.

In addition to compression in valuation ranges and toughening of anti-dilution ratchets, Sack and Goldberg reported that the typical first round liquidation preference had moved now to 3x, from the 1x of a year ago and what would normally be typical.  Moreover, preferred is now typically participating.

Similar trends (not first round specific) are logged in a Fenwick & West report on trends in VC financings in the San Francisco Bay Area.

The simple explanation for multiple liquidation preferences, I suppose, is that the economic depression gives funds the upper hand when negotiating investment terms with startups.  (I won’t suggest that the compressions in valuation come from the same place; presumably it makes sense to not overpay when we may have seen the end of the ponzi valuation era and it may not be possible to flip companies in the same way.  For more in that vein, see my “What, No Exit” post.)

But is it really in anyone’s interest, investor or insider, fund or founder, to run up the liquidation preference multiples?

Fred Wilson argues strongly, and persuasively, that multiple x liquidation preferences and participation are destructive in early round financings (and, by implication, that companies simply shouldn’t accept investments on such terms).

I found Fred’s thoughts in his recent post, “The Three Terms You Must Have In A Venture Investment.”  Although he believes a liquidation preference is one of the three essential investment terms, in a fascinating thread of comments and replies, Fred expresses serious concerns with abuses of the liquidation preference concept.  Here’s a brief excerpt from his replies to the stream of comments:

“The multiple liquidation preference is particularly damaging to the capital structure and should only be used in the late stages of a deal when a transaction is imminent . . . The participating preferred . . . is also something that isn't ideal either and should only be used when the valuation is ahead of where the company is at the time of investment. And participating preferreds should be capped.”

For the record, my clients who have closed preferred stock deals this year have, so far, not given more than 1x liquidation preferences, but a few have given participation rights where one supposes they may not have a year ago.  Then again, most of my clients are doing inside rounds right now.  Many are planning to get through this year by generating as much revenue as possible, putting off additional financings, even at the expense of sacrificing some opportunity to scale more quickly.

Thoughts From a Founder on What Motivates Founders (& What This May Mean in a “No Exit” Paradigm)

What follows is an excerpt from mail I received last night from the co-founder of a Web 2.0+ company (client), commenting on my prior "What, No Exit" post. With his permission, I’ve edited his mail slightly and am posting it, because he drills right down to the question of what motivates a person to start a company, and asks an important question of how or whether founders and investors might align interests in the new landscape. 

"We talked about this on Sunday, and it's gnawing at me, this question of how business models and the balance of power between entrepreneurs and investors are fundamentally changing in this new-new (Web 3.0?) economy."

"Here's the thing I wonder about founders:  are they typically in it for the exit, or even for the possibility of long-term operation of a going concern? Or are they in it to make their mark, to say, I had an idea that mattered – and, oh yeah, I needed some money along the way to realize my vision?"

"I might go so far as to suggest that many founders are intrinsically more motivated by delivering value to customers than return to investors. (A wise startup veteran once told me that getting funding doesn't change the business model, it just delays the ultimate reckoning.) It seems to me that the predominant model of the past couple decades has served to smooth out these discontinuities in interests by saying, in effect, 'play along and everyone will get rich.'"

"I guess what I'm asking is to what degree, in the absence of liquidity events or exits with enough to go around, entrepreneurs' and investors' interests are truly aligned. And if they aren't, what will the new models look like?"

Financial Regulation of the Venture Capital Industry, Part II

I’m noticing an interesting dialogue emerging over whether Treasury Secretary Timothy Geithner’s plans to extend regulations beyond banks, to include other financial institutions, should include venture capital funds or not.  Sparking the dialogue is the following paragraph from prepared remarks Geithner delivered recently before the House Financial Services Committee:

"[W]e recommend that all advisers to hedge funds (and other private pools of capital, including private equity funds and venture capital funds) with assets under management over a certain threshold be required to register with the SEC. All such funds advised by an SEC-registered investment adviser should be subject to investor and counterparty disclosure requirements and regulatory reporting requirements. The regulatory reporting requirements for such funds should require reporting, on a confidential basis, information necessary to assess whether the fund or fund family is so large or highly leveraged that it poses a threat to financial stability. The SEC should share the reports that it receives from the funds with the entity responsible for oversight of systemically important firms, which would then determine whether any hedge funds could pose a systemic threat and should be subjected to the prudential standards outlined above."

The initial commentary I’ve seen focuses on the point Geithner made deeper in the paragraph about identifying funds so large that they pose a threat to financial stability:  if that is the standard, what venture fund could possibly require regulation? 

But as I said earlier today in a comment to a post on this subject by noted venture capitalist Bill Gurley, the overall thrust of the full text of Geithner’s remarks, and the themes he spelled out that are not reflected in the highly-quoted paragraph, had to do not just with the systemic risks posed by those “too large to fail,” but more broadly with lack of oversight and recourse over institutions that pool and traffic in other people’s money (and yes “people” meaning not just individual 401(k) contributors but also other sophisticated institutions and investors).    Here is a flavor of those broader themes:

“We need much stronger standards for openness, transparency, and plain, common sense language throughout the financial system. And we need strong and uniform supervision for all financial products marketed to consumers and investors, and tough enforcement of the rules to ensure full accountability for those who violate the public trust.”

“Financial products and institutions should be regulated for the economic function they provide and the risks they present, not the legal form they take. We can’t allow institutions to cherry pick among competing regulators, and shift risk to where it faces the lowest standards and constraints.”

The argument made by Gurley in his post, that the VC industry did not use leverage or otherwise do anything bad to precipitate the current crisis, is I think to miss at least part of the point:  as I said in my prior post on this topic, good reform might do well to anticipate where (excessively-)creative financial types may migrate when all other avenues are rendered more transparent. 

The predominate theme in Geithner’s remarks was this: “[O]ur regulatory system must be comprehensive and eliminate gaps in coverage.”

What would be so wrong with investment pools having to register in the same manner that individual investment advisors do?  And to say, as Gurley did,and as others have implied in reacting to Geithner’s remarks, that regulation of VC funds would extend by association to their portfolio companies, is to set up a straw man.  No one wants innovative, small private companies to have to reveal competitively sensitive information.  But we probably do want a financial eco-system that is fully accountable to investors as to how money is managed, and by whom.  This information might also be useful to private companies, too, when assessing the suitability of various VC funds among their prospective investors.

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