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Thu, 09 Aug 2007 I spotted a piece by Paul Kedrosky today during a blog-feeds-catchup-session where Paul talks about a sort of "(minimum) two degree of separation" rule that VCs maintain between themselves and the sex industry. (Quotes above for my words, not his.) In other words: benefiting from infrastructure, transport, payment mechanisms -- cool. Having fleshy bits linked to from the portfolio companies page -- not cool. This reminds me of an early experience I had at Voyager. We were looking at a company that was building an online search / social media app. They talked about people using it for various applications -- consumer, enterprise, small business, blah blah blah. We were just about to the end of the pitch, when I asked pretty straightforwardly: "So, what's the sex angle here? Is there an application in dating or porn?" The room went silent. I pushed on, oblivious to the mood that had just chilled like a shot of Jaeger down an ice luge. "You know, like VHS, or modems for BBSes, or early adoption of Web marketing tricks like affiliate programs and popups," I articulated despite the intrusion of my foot now rapidly entering my oral cavity. "Is there a strategy for accelerating adoption around that content?" The founders were visibly uncomfortable. Mercifully, my boss was not pissed, just bemused. "I ... I guess people could use it for other things, too," said one of the founders, finally. Handshakes all around, a quick note on our investment process, and we'll get back to you after next week's partner meeting, ciao for now. Oops. Back at the office, this is addressed. "Randall, in the venture business, we have certain things we don't talk about, and certain things we don't invest in, due to a number of reasons." At the time, I'm thinking: OK, VCs are pillars of the community, have to show up at the Opera, at the charity events, at the B-school reunions, and can't be branded pornographer or such. I filed this away under the "shit not to talk about, Einstein" filter, along with ever admitting to listening to Journey, or denigrating tattoos while speaking to anyone whom you've never seen fully naked. But now, Paul Kedrosky gives me a flashback and with a key piece of insight. It's a follow the money moment: "... until the venture business is funded by groups other than pension funds, trusts, and endowments (ahem), the likelihood of mainstream VCs ever getting beyond flirtations [[with the sex business]] is vanishingly small." Yep, follow the money. The paymasters here are the Prudent Men, the real stodgy guys, the Trustees and the Chairmen and the Stewards and the Overseers. And frankly, this is probably a good thing. It's a little like the Senate. You don't want the country entirely run by a bunch of pasty old white dudes, most all millionaires, 60 years old and who won't be fired for 12 years (on average), and who probably still think that Kudzu and the missile gap are our biggest national problems. But you don't want a bunch of whippersnappers on the make driving all your big decisions without recourse to the accumulated wisdom of years past. The real test will be if one of the trendsetter endowment funds like Harvard or Yale green lights a VC or PE investment that targets the sin sectors. If that ever happens, then the VC business will start to get a lot more (directly) involved in the naughty bits... $Id: vcs_and_the_naughty_bits.txt 969 2007-08-09 18:19:32Z rlucas $ Wed, 08 Aug 2007
Liquidation Preferences: A Response to Leo Dirac
In a recent blog entry, Leo Parker Dirac poses the question of the fairness of liquidation preferences in VC financings of startups. He's going to be delivering a lightning talk based on it tonight at Ignite Seattle. (To those of you who don't know, liquidation preferences, or prefs, are usually a multiple of invested dollars that a VC gets out first, before anyone else is paid. This is because if you take $10 M from a VC for half your company, then shut down the company one second after depositing the VC's check, he would only have a claim on half of it, thereby snookering him out of $5 M. To avoid this outcome, and due to our general greed, we VCs like to ask for at least a 1.0x preference, meaning that you have no incentive to shut down the company until you've grown it to something more than our investment dollars.) His conclusion seems to be that liq prefs can be fair if transparently communicated to all parties. Of course, this implies that sometimes, details of prefs are not communicated clearly. How can this be? I've seen many tens of term sheets, and never once have I seen one that uses invisible ink. Neither have I ever seen a term sheet that has a clause invalidating it if you show it to your lawyer. In short, there is never a case where an entrepreneur isn't reasonably informed about prefs. Let me construct an example. Say that you're a first-time entrepreneur, and that you don't have anyone on your exec team, nor on your board of directors, nor among your existing investors, who's ever seen a term sheet before. (I was in that spot starting my first company back in 2000, by the way.) And, let's say, you get hold of a term sheet that casually throws out there something like "holders of Series A shall be entitled to an amount per-share equal to two times the per-share price..." and you don't know what it means. Well, one thing I can absolutely promise you is that no VC is trying to sneak one by you for a shot at 2x his money. A VC investment just takes way too much heartache and worry and effort -- not to mention opportunity-cost of not investing in the billion-dollar blockbuster every VC's looking for -- for a VC to fuck around with taking a chance at cheating you out of a couple million (remember, he has to give all but 20% of that profit to his investors, and split that 20% through some formula of his partnership, so even if he cheats you out of $5 M he's not going to deposit more than a few hundred $k in the bank, and that's at risk of losing his several hundred $k per year sinecure for a GP of a decent-sized fund). Another thing I can promise you is that no VC ever wants you to sign anything without reading it and having your lawyer read it twice. Think about this one for just a second: I'm about to wire you enough money to buy twenty or thirty Porsches, based on the notion that you're a brilliant businessman who's going to make us both rich. Do I want to give thirty Porsches worth of cold, hard cash to the kind of guy who signs deals without reading the contract??? Seriously: I want you to be the slickest of salesmen, the toughest of negotiators, and the most diligent of dealmakers (not to mention a prodigious engineer, a revered leader, and a master marketer). VCs do not want to give money to sloppy suckers who can't be bothered to read and understand a term sheet -- including seeking savvy legal counsel when appropriate! Now, having said all this, there are at least two cases where Leo's thinking really does apply to the question of liq prefs. (It shows of Leo that his thinking on the matter of prefs is mostly abstract, that he does not mention either of these two cases.) The first case is where you are dealing with a fake VC. A real VC is someone who spends full time managing a fund of committed capital from one or more arm's length investors, which capital amounts to at least, say, $10 M per general partner and is entirely meant to be invested in growth companies for the purpose of financial returns primarily via capital appreciation. A fake VC is anyone else who calls himself a VC without pointing out the major differences with the above. And a fake VC has God-knows-what sort of motivation and may well want to swindle you out of a preference multiple. Your uncle who owns a chain of bagel shops is not a VC. A hedge fund is not a VC. A dude who claims to represent a group of "anonymous Asian industrial families" is not a VC. Anyone who is keeping his day job is not a VC. Real estate guys are not VCs. Note that this doesn't mean they are bad people (unless they pretend to be VCs, in which case they are fake VCs). It just means that the ground rules that you can understand all VCs to play by don't apply. If you're not dealing with a real VC, read everything three times and have your lawyer read it six. The second case is in follow-on rounds where the company is in a distressed situation. Everything Leo talks about (and everything I assume in the first part of this post) is about the moment before you take your first VC investment: do I take this capital, with its strings attached, for a shot at building my dream? The alternative there is to simply walk away, and go back to working at Microsoft. But once you're hot and heavy with a company, once you've raised money, promised the moon and the stars to your friends and family, bamboozled the VCs into funding you, alienated all your social contacts and exacerbated your RSI, hired fantastic people and worked them to exhaustion and made them love you enough to drink the Kool-aid, extended commitments based on your word and your honor to customers and suppliers -- only to find that revenues aren't ramping up fast enough and you need cash -- OK, now you are officially up against a wall. And precisely now is when you will be addled from overwork, and adrenalin-high, and blinded with the urgency of your need -- and when the sharks will smell blood. That is when you will get the predatory term sheet. If Leo wants to do entrepreneurs (and VCs) a favor, he should take a hard look at what happens then: when you've got a company that still holds promise, but is in a distressed situation and needs capital for its very survival. Exploring those moral complexities is a lot more interesting than the sort of clean-room, game-theoretical chatter about whether one accepts term X on a first round of capital. $Id: vc_liquidation_preference_response_to_dirac.txt 966 2007-08-08 22:49:34Z rlucas $ Mon, 16 Jul 2007
VC Career Snippets: "The Wormhole"
This is the first of a series of "snippets" about getting a job in VC. I get asked about this approximately weekly, so I am going to try and do a highlights reel of things I tell people or thoughts I come up with on the topic. In a nutshell, VC is this weird parallel universe into which there are very few wormholes. (To start a career in VC) It helps to distort the space-time continuum with an extremely concentrated mass of money that you already have. $Id: vc_career_snippets-wormhole.txt 948 2007-07-17 02:32:19Z rlucas $ Wed, 21 Mar 2007
VC Essential Tensions: Momentum vs. Contrarianism
It is my intention to begin a series of entries dealing with "essential tensions" in investing in general and VC in particular. This is the first of the series. Venture capital as an industry deals with momentum investing. Paul Kedrosky has argued on his Infectious Greed blog that VC is a "bubble business," and that venture returns, when they're good, come from momentum-fueled exit events. This is an argument where the counterexamples are the exception that proves the rule: Google's IPO (unimpeachably a deal that stands on its own merits rather than a momentum exit) stands out for having decisively ended the exit drought that had plagued the industry since 2001. Indeed, GOOG going out kicked off the recent positive-momentum exit cascade that gathered steam throughout 2006. Likewise, on the "entry" side of new financings, momentum tends to rule the day (especially when exit momentum "spills over" into fundraising and new financing activity). See, for example, the cavalcade of YouTubettes that have been trotted out, freshly funded and hoping to hit warp 10 and slingshot off the perceived stellar performance of online video and user-generated content. (Indeed, it would take some backwards time-travel for most of these to capture any fraction of the value in that particular space.) It is easy self-righteously to laugh at the absurdity of funding 30 YouTubes. But if we accept whole-heartedly the ad absurdum version of Kedrosky's argument, we can't blame VCs for believing in momentum. After all: if folks today are buying online video companies, then the savvy VC better have one to sell. But investing is not a game played alone, and contrary to the bluff and bluster of some VCs, no deal is "binary." Every deal is implicitly an auction, with a bid and an ask, and the formula for investment return is ancient and venerable: buy low, sell high. Momentum helps with the latter, but crushes our ability to do the former. Apart from the occasionally perverse incentives provided by large, fixed fund sizes, pricing going in is even more leveraged in ROI than pricing coming out. Getting into a good deal at an attractive price -- and hence, the longer lever on ROI -- depends on a virtue diametrically opposed to momentum, namely, contrarianism. The contrarian looks for undervalued purchasing opportunities by ignoring or subverting the prevailing wisdom of the day. He makes it his job to call the tops or bottoms of markets, and sometimes is the one declaiming the emperor's nudity. An occupational hazard of this is that sometimes, the market has a ways to go yet, and occasionally the emperor still has flesh-colored tights on -- and early is the same as wrong when timing markets. Certainly, if there is a mythical hero of venture capitalism, it is the steel-nerved visionary contrarian who makes what looks like a long-shot bet, boldly doubling down when others are fearful, and propelling forward great companies and great technologies that nobody else dared touch (and hence, that he invested in on the cheap). Where else do we get the nerve lionizing our asset class as "venture?" So, we are faced with a contradiction between the mythology of our industry and the harsh reality. You don't get to be both the visionary contrarian and still have the online video portfolio company. Why do so many venture firms seem to choose momentum in this tradeoff? I have two theories. One is that, although entry price has more theoretical leverage over ROI than does exit value, exits are so much more visible that they dominate the consciousness of most VCs. That is, given the implicit opportunity to make a 8x ROI on, say, a $60 M exit, or to make a 2.5x on a $500 M exit, and assuming that the probabilities and amounts are adjusted to keep other comp and performance measures ceteris paribus, I bet that VC decision processes are strongly skewed to the big dollar, highly visible exit. Half-billion IPOs are much better bragging fodder at the VC confabs than mid-market M&As, even though the latter may well pay off better. This would be a great master's or Ph.D. thesis if one could substantiate and measure the value of this skew. The second theory is a general theory for understanding why contrarianism, itself, is "meta-contrarian" (that is, why contrarianism is selected against as an investing style). I call this the "rich friends theory." I use it to explain why, despite all rationality, U.S. investors tend to overweight U.S. equities in their portfolios. In a nutshell the theory is this: it sucks far worse to miss out on an investment opportunity that all your friends have scored on, than it does to miss out on an equally profitable opportunity that everyone else missed, too. Put another way, it's awesome to get richer than your friends, but it's way worse to get much poorer than them. Thinking of this "peer-relative risk aversion" helps to understand a lot of bubble / momentum dynamics. This, too, would be fascinating to measure, although I can reasonably set a lower bound here of 0.7% skew toward the crowd, which is the "rich friends tax" you pay in incremental house edge at craps by playing the pass line (the "do's," where most players play, has a house edge of 1.41%) vs. the don't pass line (the"don'ts," almost diametrically opposed to the do's, where winning earns you enmity and losing earns you jeers from your fellow punters, has a house edge of 1.40%). There's also a case to be made that emerging managers hew more closely to the herd because it could be an existential crisis to a firm for its first fund to be a "fourth quartile" performer. Much better for a new firm to post median returns and live to raise more funds, than for it to risk lagging returns on a series of contrarian bets (better, that is, for the firm, if not for its investors, who may in fact be better served by the longer-shot odds). This is, of course part of the "tyranny of IRR," about which I have another blog entry under preparation. I wish I could say that understanding, or even measuring, these effects gives you some kind of instant edge in investing. But, alas, this is a perfect example of the occasional frustrating impotence of mere understanding. (I do have some ideas for exploiting this particular case, but those obviously aren't public.) $Id: vc_momentum_vs_contrarianism_essential_tension.txt 838 2007-03-21 20:31:25Z rlucas $ Mon, 12 Mar 2007
VCs Are Not Your Channel (But They Might Be Your Friends)
Occasionally I get calls from folks who get the bright idea that, since VCs have a bunch of portfolio companies under influence, they can leverage selling their stuff by talking to me instead of pounding the pavement to the whole portfolio. If you're thinking of doing this, remember that we (VCs) are not your personal sales channel into our portfolios! Consider:
Now, all that said, there are some cases where using VCs for leverage into their portfolios does make some sense.
What should you do if you decide to make the pitch?
I personally try to be helpful to decent and courteous sales / biz dev folks, but I think that reading and acting on the above is a bare minimum level of courtesy for sales / biz dev people talking to VCs. $Id: vcs_are_not_your_channel.txt 833 2007-03-12 23:13:51Z rlucas $ Wed, 31 Jan 2007
Hint: Nobody Has Any Idea How This Thing Works
In Venture Capital, we have lots of rules of thumb for assessing entrepreneurs. Some such rules are:
When you've got guidelines like this, many of which are quoted with nary a trace of irony by the practitioners of our art, it's fairly clear that you actually don't have any useful guidelines. Except one: invest in guys who've done it before. The only person you know has a shot at creating a company with an exit value over $100 M (which is about the minimum exit value that most VCs would admit to wanting in any case, so I'll use this as the threshold for my definition of a "star entrepreneur") is the guy who's already done it. Everybody else hasn't yet proved it. However, we have a major signal-to-noise problem here. When you look at an entrepreneur, even if he's a star, you don't know to which causes and in what proportions to attribute that stardom. Certainly, the quality E of star entrepreneurship could be the cause. But it could also be quality L (for luck). With only one exit, you just don't know. But with no exits, you know even less. If you were a statistician, you might try doing something with a Chernoff bound or a Z-test to figure this out. But a few things confound this approach. The main problem is that your number of trials is usually one. You can't just keep tossing the coin to see if it comes up heads 51% of the time; you have to somehow guess the bias after only one flip (no pun intended!). Another big source of error is that successful exit events are fairly rare. Most venture funded companies don't have successful exits. (The old chestnut about VC is that a fund makes ten investments; five fail, 3 or 4 return 1x capital, and 1 or 2 make a 10x return. That's hardly accurate, but it's a good enough schematic for understanding the rarity of successful exits.) So if the probability of any given entrepreneur having a successful exit is 10%, then even a "rock star" who is five times better than the average is still only even money to exit big. So, we have lots of both Type I and Type II errors. Finally, successive startups are not independent trials. That is, unlike rolling the dice, each startup you do is affected by the previous ones (both the experience of doing them and the ultimate outcome). Even when an entrepreneur has been successful in the past, we don't know if he's likely to be successful again (though we can say, on average, he's more likely to succeed than a newbie). But often, we fail to reject the guys who "hit the lottery" with their previous success. And even more often (almost by definition), we end up rejecting highly promising entrepreneurs who haven't yet had a home run. Yet, somehow, VCs continue to invest, and the returns (compressed due in large part to excess capital seeking a home in alternative assets / private equity) have continued to be good (if less princely than in the early years of VC). So VCs aren't just monkeys throwing darts; we do have some discrimination ability. Another chestnut in the VC industry is that "it takes $X million (e.g. $30 million) to make a general partner." That is, to get a venture investor to the level of a seasoned senior investor, he needs to have led $X million in deals. This amount of deal flow (or, as it's sometimes told, losses) is required to build up the black box of intuitions, gut feelings, sixth sense, etc. that a good general partner should have. To me, this is a bunch of horse hooey. Yes, any good seasoned professional in any field will have some pre-rational judgment abilities that appear to be a "black box" -- but these should only come into play at the margin. The core of any professional discipline must be reducible to a teachable, coherent syllabus. Take, for example, Malcom Gladwell's example in Blink of the use of the Goldman algorithm for diagnosing acute myocardial infarction (heart attack). Essentially, the algorithm kicks the ass of expensive cardiologists and other "professionals" at doing one narrow thing, which is telling whether a heart attack is happening. Now, the human body is a system, replicated and observed over billions of instances, with trillions of dollars cumulatively spent on measuring and exploring it. It provides feedback continuously on a second-by-second basis. And a heart attack is a fairly catastrophic and disruptive event -- the death of part of the most important muscle. So the fact that a relatively simple algorithm can discriminate that event with great specificity is perhaps unremarkable. But what is remarkable is that it took until the mid-eighties to promulgate the Goldman algorithm, and even today it's not the gold standard. (Hey, at least medicine has the Goldman algorithm: in VC, nobody yet has validated such an approach.) Doctors and VCs both have acute cases of what I call "special snowflake syndrome:" both groups tend to believe that they have special, irreducible talents and skills at doing whatever they do, and that they could never be replaced by a dumb machine. It is no coincidence that special snowflake syndrome tends to strike those in high-income jobs; folks who've seen automation or offshoring put downward pressure on their wages tend not to subscribe to this conceit. We also see special snowflake syndrome in industries where there are relatively high barriers to entry, such as regulatory (medicine) or timing / liquidity (10 year partnership agreements in VC). In both cases, special snowflake syndrome will inevitably lead to heartbreak as people without the illusion of snowflakeness find and implement things like the Goldman algorithm (and the coming, immodestly named Lucas algorithm for VC). Unfortunately for the doctors, they won't be capturing the economic surplus that results -- it will be the middlemen in the hospitals and insurance behemoths that soak up the savings. (Doctors: save yourselves now, by demanding economic ownership of your patients' well-being, the only humane and just way to allocate costs and risks in your profession!) Fortunately for VCs, the implementation within a partnership of the Lucas algorithm will enhance that firm's ability to identify and make successful investments with greater certainty and less manpower. And since VCs, through the carried interest portion, are compensated on financial performance, this will ultimately benefit the adopters. Yes, there will be some Schumpeterian woe for the old-school hangers-on as the snowflakes of their egos are melted in the sunshine of the new day that will be ushered in. And yes, a certain few of the old-school VCs -- the ones with really great black boxes and/or Rolodexes -- will continue to enjoy their maverick road gambler reputations. But by and by, rationality is coming to our market. Our black boxes will help us make decisions at the margin, but our algorithms will drive our core activities. Does anybody want to work on the algorithm with me? (I'm willing to hyphenate the name of the algorithm.) Drop me a line or give me a call at Voyager, +1 206-438-1822. (There will, of course, be several variations for different industries, geographies, stages, and firm preferences -- so much so that each firm will likely need its own implementation -- which is why I'm not too concerned about giving away competitive advantage by discussing with others in the industry.) $Id: hint_nobody_has_any_idea_how_this_thing_works.txt 833 2007-03-12 23:13:51Z rlucas $ Tue, 16 Jan 2007 In a post entitled The Venture Capital Aptitude Test, quasi-famous blogger and sorta-VC Guy Kawasaki rags on junior venture investors in general and on young VC associates in particular. He prescribes "contempt" for "any young person who opt[s] for venture capital" and implies that such people are "full-of-shi[t]" (saying "shiitake" when you mean "shit" is just barely cute enough to countenance the first time, Guy, but let's call a deuce a deuce). In other words, Guy Kawasaki hates me. Now, I am by no means the archetypal target of Guy's scorn -- his sharpest comments are reserved for MBA and I-banking types without operating experience, and he has a soft spot for those of us with engineering and sales backgrounds. I have, in fact, nothing but operating experience (two software startups, one profitable, one defunct) in my career to date, but being in my late twenties and working for Voyager Capital is inexcusable to Guy. Guy sets up a straw-man argument, viz: 1. Working in VC is the best way for a young person to learn entrepreneurship. 2. Young seekers of VC positions are motivated by gigantic ($500k) salaries and massive carried interest portions. 3. Young VC associates are great candidates for shepherding along startups through their challenges. Unsurprisingly, Guy knocks down that straw man, says "shiitake" a couple times, and then congratulates himself. Hurrah! He does so with the help of an interactive, Cosmo-style quiz that asks fairly shallow questions about who one is ("background"), what one has done ("first-hand experiences"), and what knowledge one has ("necessary knowledge"). Cognitive dissonance must set in for him around here, since his California-Bay-Area-influenced emphasis on "direct experience" was offset by an ancien regime-style weighting toward character and background (it's Baba Ram Dass vs. the Greek chorus). Finally, Guy racks up the comments -- mostly strokes for Guy with a bunch of self-reported high (or low!) scores and self-strokes -- and takes the very odd approach of appending his replies, separated by a line of asterisks, to the three negative comments that dared to challenge his post. Where should my criticism start? A decent kickoff would be to work backwards through his straw-man points. Guy's pointing out that VC associates aren't necessarily the best mentors and board members for startups is not only obvious, but pointless. A VC associate isn't supposed to be the wizened old sage who shepherds a company to success; indeed, I would suggest that in most VC firms, associates aren't even allowed to take board seats. Guy disingenuously ignores the idea of division of labor. A quick primer on investment team roles for those who aren't familiar with finance (from which VC borrows a lot of titles):
Associates and analysts are generally MBA or pre-MBA types, and are expected to do much of the due diligence, financial modeling, and to follow up on the colder end of the lead spectrum (all the way down to cold calls, in some cases). In effect, they are doing exactly the work that their MBA, I-banking job, or consulting gig prepared them to do: spreadsheets, ginning up pitch books for LPs, reading of contracts and term sheets, talking to people and vetting their credibility, sanity-checking business models, etc. It is at the GP / MD and Principal levels that advising of portfolio companies comes into play. (Now, will you in practice see overzealous associates running their mouths in situations they shouldn't? Of course; in the mix of ambitious people you hire associates from, you'll get some arrogant and / or impudent overachievers. But it's the exception that Guy takes for a rule.) And, if anybody is making the mythical $500k salaries, it's folks in the GP / MD bracket. But don't take my word for it; you can make a reasonable estimate of GP salaries for a given firm. Simply multiply the total assets under management of a VC firm by a reasonably high management fee (say, 2.5%) to find a credible upper bound for the firm's non-carry revenues (ignoring for the moment "franchise" firms that essentially license their brands to others). Then, take a slice off the top (say 25% minimum) for rent, support staff, auditors, lawyers, insurance, and any "private jets" that Guy imagines, and you've got the total allocable to investment team compensation (salary, benefits, etc.). Let's take Guy's firm, Garage Technology Ventures, for example. They've raised a first fund rumored to be $20M (with CalPERS as the "principle [sic] limited partner"), and possibly a second fund. Let's assume that there's a second Garage fund of $40M. That would bring total AUM to $60M; 2.5% fees would gross $1.5M annually for the firm. Let's slice off 25% for rent, etc. -- now we've got $1.125 M. Garage has three MDs and two VPs (venture partners); let's assign the MDs 3x the salary of the VPs (who are probably part-time). That gives us 11 units of salary from the $1.125, or roughly $300k per MD and $100k per VP. Don't forget that a chunk of that goes out the window to the employer costs of payroll taxes and benefits, so you're probably looking at base salary to the MDs of more like $200k and to the VPs of perhaps $75k. That took about three minutes (and I don't even have a Wall Street I-banking background!). Admittedly, Guy's firm is a remarkably small VC in terms of assets under management. Still: would any sane ex-banker think he has a shot at $500k base by going to work for Guy or any other VC? Clearly, nobody is asserting these silly ideas (except Guy's man of straw). This brings us full circle back to the straw man's original plank: that VC is a great way to learn entrepreneurship. Well, precisely, this is false, and we must grant Guy that concession. There are a thousand things an entrepreneur must do that a VC associate, no matter how duly diligent he may be, will never observe him in. But merely because the VC vantage point is insufficient to learn entrepreneurship does not mean that it cannot be helpful. Indeed, to the extent that raising investor capital (from someone other than your inner circle) is something you foresee doing, being on the VC side of the table is remarkably helpful. I speak from experience here: I roughly bootstrapped two startups using a combination of the five F's: Friends, Families, Fools, Physicians, and Float (off of credit card convenience checks!). Yet my knowledge and ability concerning raising investor capital was nil. After my time so far at Voyager, I now have a relatively huge sample size to see what works and what doesn't (and why!) in investor pitches. Now: if I had spent the last two years pitching VCs, would I have more and different knowledge about entrepreneurship than that which I gained listening to such pitches? Certainly. And it's almost undoubtedly better for the skill of raising capital to actually practice raising it than to observe others pitching you. But to the 25-year-old entrepreneur without a "base hit" or previous connection to the venture industry, practicing raising VC by just doing it isn't generally a realistic option. Guy also ignores the fact that a VC is supposed to be different from an entrepreneur. They operate on different logical levels; a VC must be at a meta-level to the entrepreneur's. Meta-level occupations, such as consulting or I-banking, prepare individuals for this by having them view many businesses and compare among them for patterns, valuations, etc. It's the difference between being an antiques appraiser and being Carl Faberge. A better and more useful caveat to young VC position-seekers is simply to remark on the dearth of positions available. There are, to a first approximation, no jobs in VC. If VC wants you, it'll find you; if not, you're almost certainly better doing something besides quixotically questing for a junior venture job. That said, I chose VC as a detour on my route to entrepreneurship. Although I wasn't originally looking for VC as a next step, it was recommended to me by one career advisor around the same time as I learned of an open position looking for an analyst with operating experience. The money isn't princely, but it's steady. The learning isn't everything I'll need to succeed, but it'll help. And frankly, it's absolutely a blast and the next best thing to starting my own new company. A final note: a subtext to Guy's entry and its comments implied that junior VC personnel were all young whippersnappers who couldn't hold a candle to the grizzled but worldly wise entrepreneurs they worked with (and that they ought to hold their tongues besides!). That thought is OK, I guess: I certainly am humbled when I have to communicate a pass to a repeat entrepreneur who's sold more companies than I've founded. But seriously: if you're a tough, worldly entrepreneur who gets offended by talking to some young VC associate, you need to suck it up and give less of a shiitake about what us whippersnappers say. $Id: guy_kawasaki_hates_me.txt 833 2007-03-12 23:13:51Z rlucas $ Thu, 10 Aug 2006
Earnings Calls in a Trippy Vortex
Today, I called up a news release on finance.yahoo.com for a fairly dodgy publicly traded company. Although I expected to find a transcript of the earnings call, or perhaps a brief table summarizing the expected and actual earnings numbers, I was given a link to the full audio of the call. When I clicked the link, a full-screen window of Windows Media Player popped open and started playing the earnings call, with a huge, trippy, psychedelic vortex being rendered in the middle of the screen! (As it happens, a mind-warping black hole of profits is the most appropriate metaphor for what this earnings call was all about.) Thanks for a bit of inspired weirdness, Microsoft. It was certainly more enjoyable than discovering that your flagship email client can't "archive" two folders at once. $Id: earning_calls_trippy_vortex.txt 694 2006-08-10 22:57:14Z rlucas $ Mon, 17 Jul 2006
VC Annoyance: Term Sheets Excluded from Closing Book
The Closing Book of a financing is the definitive collection of all documents relied upon in conducting a financing. It will generally have a "snapshot" of critical documents before and just after the financing, such as the original Articles of Incorporation dated one day, and the "amended and restarted" articles dated the next. Other agreements such as Investor Rights Agreements and Stock Purchase Agreements are included as well. However, much to the chagrin of analysts like myself who often have to go back to the closing book for reference purposes, the actual term sheet often is not included in the closing book! This is most frustrating, since as a practical matter it is usually more relevant to discuss "term sheet to term sheet" when comparing terms or negotiating a subsequent round, rather than referring to definitive legal documentation (I estimate that the ratio of words and pages in a term sheet to those in the definitive docs based upon the term sheet is around 1:250). I believe this is because attorneys are loathe to include anything in the closing book that might give even a thin entering wedge of challenging the definitive docs. Specifically, if a term sheet is included, a party might contend that the term sheet was the "parent" of the documents that followed, and should therefore inform the interpretation or construction of the definitive docs. This may be a legitimate concern, but damn it, lawyers, couldn't you just stamp: "non-binding, subject to the definitive documentation" in red all over the term sheet and stick it in the closing book?? $Id: vc_annoyance_term_sheets_in_book.txt 671 2006-07-17 18:43:06Z rlucas $ Mon, 10 Apr 2006
Venture Capital Jargon and Terminology
2006-04-10 Randall Lucas It's been just over half a year that I've been working on the "other side of the table," as a VC analyst at one of Seattle's leading venture firms. Something that was helpful to me in my first days on the job was reading blog postings from Brad Feld and Fred Wilson, explaining terms of art in the VC world, like "participating preferred," "liquidation preference," and the like. Both as a personal reference tool, and in order to help out folks (be they new analysts / associates at a venture firm, or entrepreneurs) who are faced with rapidly coming up to speed on the jargon of the industry, I'm preparing this miniature glossary of VC terms. I'm targeting the reader who's responsibility is actually modeling the effect of these terms once in place, rather than negotiating them ex ante, so commentary is biased accordingly. Antidilution ProtectionA right of preferred stockholders to increase their effective number of shares in the event of a subsequent dilutive (lower per-share price) sale of stock. AKA "the (full or partial) ratchet." For preferred stock, antidilution protection is usually effected by an adjustment in the conversion price (or ratio). For example, if you bought at $1.00 per share, you would normally convert to common at $1.00 per share (1:1 ratio). For reasons of antidilution, your conversion price might be adjusted to $0.75 per share (1.5:1 ratio). How this is calculated depends upon the type of protection. Antidilution protection is usually either "broad-based" or "narrow-based" -- these represent the "partial" ratchet, and are based upon a weighted average. In broad-based antidilution protection, you would typically reduce the conversion price using a factor derived as follows: For narrow-based protection, the factor is derived similarly, but instead of CSE for the old share count, a much smaller number may be used (such as only the then-outstanding common shares). Investors naturally prefer narrow-based to broad-based when choosing a weighted average antidilution clause. However, the rational investor will prefer most of all the "full ratchet." This clause simply adjusts the conversion price on the old shares to the new share price. In the event of a "down round," this jacks up the prior investor's percentage ownership in a major way. In fact, however, the "full ratchet" is not aggressively pursued by many VCs these days. Although it is theoretically favorable to him who holds it, it paradoxically may turn off a subsequent "down round" investor and wash out management's skin in the game at a time when that capital and talent are most needed. CarveoutA distribution upon liquidation which is set aside ("carved out") for the management team, often at the discretion of the Board of Directors and ahead of equity distributions. One purpose of a carveout is to ensure that management stays motivated to effect an orderly wind-up of a company even when their equity compensation is likely to be modest or nonexistent. Other sources: Gray Cary Common Stock Equivalents (CSE)The number of common stock shares for which a given security may be exchanged or converted; includes things like preferred shares as-converted, options, and warrants. However, it behooves the analyst carefully to read the documents in question; varying types of calculations calling for the fully diluted share count may have differing rules (e.g. for options, one might count all authorized, only granted, or only "above water"). DividendsPreferred stock often has a dividend clause; a typicaly amount and character of dividends I've seen is "8% annual, non-cumulative, in preference to junior stock, when, as, and if declared." The last part -- if declared -- is the key issue here, since dividends rarely if ever are declared by startups. The consensus I've gotten in this part of the country is that dividends are typically a non-issue, but that a dividend clause is added to block shenanigans such as a dividend to common shareholders to circumvent the liquidation preferences. Sometimes, preferred stock will have a mandatory dividend associated with it as well; this is more likely to be seen in mature companies than in startups, and I have never had to model it. This might also be different in different regions. Drag-along RightThe right to compel other shareholders to approve a liquidation transaction ("drag them along" with you). Usually afforded to a supermajority of preferred shareholders (either a specific class, or preferred holders voting together). (Update 2006-06-19: Brad Feld introduces his readers to a variant of a drag-along right, termed a "compelled sale right," in which the right is attributable to a particular minority shareholder rather than a majority or supermajority. Shockingly, in Feld's example term sheet, this compelled sale right is given to a 10% CSE owner.) Liquidation PreferenceA right of holders of a series of preferred stock to receive, before any other distribution, a specified payment, typically a multiple (such as 2.0x) of the original purchase price. AKA "two times money out first." Liquidation preferences are either paid in rank order (e.g., Series D preference first, then Series C, then Series B, etc.) or pari passu (according to each series' percentage of the total preference amount). Once all the preferences are paid, then the rest of the proceeds are split among the holders of common stock (but see Participating Preferred, below). The choice of converting to common vs. taking a preference, in a multiple-series capital structure, can lead to some pretty hairy financial models; caveat Excelor. One big thing to remember is that the decision of one series can "cascade" to others, since the first series' decision, by definition, will be changing the amount of proceeds available to others. Very rarely, common stock has a "liqudiation preference" as well (no joke -- I've seen it with my own eyes!). Other sources: Brad Feld on liquidation preferences; Participating PreferredA series of preferred stock which, in addition to any liquidation preference, gets to participate in the distribution of proceeds to common stock on an "as-if converted (to common stock)" basis. AKA "double dip." In non-participating preferred, a preferred investor must choose either to receive his liquidation preference, or to participate on an as-converted basis. For small exits, the preference is better; for large exits, the participation is better. Participating preferred is known as the double dip, because the investor gets both. Sometimes, this clause is combined with a "cap" on the participation amount, which is, in a tricky way, equivalent to non-participating preferred with a big "invisible preference" included (because the investor still faces a "tipping point" where it is better to convert to common; it's just a much higher number). Other sources: Brad Feld on participating preferred; Redemption RightThe right of a stockholder to require the company to buy back his shares. Like with dividends, this is almost always present, but very rarely invoked for startup deals. Typically, the redemption right specifies the price of redemption and a timeline (e.g. 1.0x, monthly over two years). Most often, this right requires some kind of supermajority of preferred holders for its exercise. Warrant CoverageIn conjunction with another financing, the issuance of warrants to purchase stock in a quantity usually specified by a percentage of a principal amount (e.g., 10% coverage on a $5 M bridge loan would be a warrant to purchase $500k of stock). The actual price for the warrant exercise might be the then-current price, or it might be dependent on the conversion price of a convertible note. Warrants are usually "sweeteners" added onto debt rounds by venture lenders; chances are awful good that if you look at the warrants section of a few cap tables you'll come across "SVB" before long (Silicon Valley Bank, one of the usual suspects in venture lending). $Id: vc_jargon.txt 631 2006-06-20 17:03:09Z rlucas $ |
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