I just did a post on OnStartups about how to take a cold call from a venture capitalist.
Few venture backed entrepreneurs understand the concept of “reserves.” Reserves are uninvested capital that the venture capital fund sets aside for future investments in a startup. As Atlas Venture VC Fred Destin explains on his blog, “When investors commit to your company, they will invest some money upfront (say $2M) and allocate reserves for future funding (say $6M). Why ? Well, we know from experience that successful businesses take real capital to get to the finish line.”
Fred has a solid post on what happens to reserves when your company underperforms.
I just got back from a great almost 2 week trip to the Southwest, so haven’t blogged at all. Trying to get back into the work environment – lots to do, so just a quick link to a good post by Rob Go on super-angels and micro-VCs.
I attended Angel Boot Camp yesterday (June 1, 2010) at the Microsoft NERD center. It was a great event with something close to 300 angel investors gathering to discuss how to activate the angel community in Boston. Jon Pierce of the Awesome Foundation organized everything – nicely done Jon! Here are a couple articles/posts on the Boot Camp from the community:
Wade Roush of Xconomy published a great summary of the speakers main topics.
Also, Don Dodge put the key points from his talk up on his blog “The Next Big Thing.”
two more posts inspired by Angel Boot Camp:
Will Herman on Angel investing – why he does it and what he gets out of it, plus some ground rules for success.
Brad Feld on suggestions for angel investors.
And another Angel Boot Camp post:
Gabriel Weinberg was reminded of how much he likes backing hackers and needs to make more investments.
BostInnovation on the first sessions of Angel Boot Camp.
A good piece on how VCs do not want to read a huge word processor prose-style business plan: http://upstartadvisors.wordpress.com/2010/05/19/4-reasons-not-write-a-40-page-business-plan/
The punchline is that the post’s author surveyed 50 VCs and angels and 95% of them did not want to get a big word document!
There was a good blogosphere discussion this weekend on liquidation preferences during seed and VC investments. Fred Wilson once again has the best thoughts on participating preferred on his blog. It’s a great read for anyone negotiating with an investor for their first fund raising round on what participating preferred is and also links to explanations on liquidation preferences.
Update – Upon rereading my post and being contacted by Gabriel (who I am about to mention) I’d really like to point out that I’m not trying to personally attack him. It sounds like he’s a very, very smart guy who has built a few businesses to the point where he is able to be an angel investor. This is no small feat! Furthermore, promoting entrepreneurship and making angel investments is something that should be celebrated, not attacked. I do have some issues with his post on liquidation preferences in angel rounds, though.
During this discussion I came upon what I thought was going to be informative post on liquidation preferences by an angel investor in PA, Gabriel Weinberg. He links to a few spreadsheets in his post that supposedly make the case that it’s cool to take an angel investment with a 2x liquidation preference. He makes the points in these sheets that as an investor, with a 2x liquidation preference he can make a 15% IRR even if he invests in a company who’s value drops from $3 million at his investment to a $1 million exit 5 years later. That is one of the largest mis-alignments of interest between an investor and an entrepreneur that I can imagine.
He also seems to think that later round investors will be ok allowing him, the earliest investor, to keep his out of whack liquidation preference AND not insist on having one themselves. There is no chance a good investor will allow this. In fact, having out of the norm terms (like aggressive liquidation preferences) have a very high % chance of torpedoing your company’s ability to raise capital from a sophisticated investor. When the VC firms I worked for saw aggressive terms like these in seed investments, we usually passed on the investment right away. This is because it is a sign that you are going to have to deal with an unsophisticated angel investor, and most VCs would rather have a lobotomy than waste time negotiating with an angel who thinks they know what they are doing but don’t.
To illustrate my point that unsophisticated angel investors with large liquidation preferences are dangerous, I’ll share a story of a deal-gone-bad: I saw a company’s angel investors blow up an investment that would have been GREAT for the company and entrepreneur. Basically, the angels would have had to have lost their super-liquidation preferences. The company was cash flow break-even, but could have used my fund’s $10 million investment to grow to potentially be a $100 million plus company – but because the original investors were sitting pretty on a cute little return (very safe at this point, since the company could generate cash by stopping investing in growth) with their preferred structure, so they rejected the investment. Note that this crushed the entrepreneur’s dreams of growing his really great company into a big firm in the next couple of years. And my firm wasted a lot of time negotiating with these investors. I still feel really bad for the entrepreneur.
There are only two times it makes sense to accept over a 1x liquidation preference:
- The investors are letting you cash out at the time of the investment (i.e. the money they are investing is going into your pocket.)
- This is a B or C round and your company is having real problems. VCs will sometimes then insist on punitive terms to try to make up for the fact that they know their initial investment(s) in your company are likely to not produce returns.
VCs for a long time highly encouraged convert investing by angel investors. Angel investors have been clamoring for more respect and believe that they should be encouraged to invest in preferred stock with a valuation, instead of investing in convertible debt that turns into whatever the next round’s structure is at a discount.
Update: There was an issue with the model shared in Gabriel’s post, but he has since removed the problem. I believe it is dangerous to let non-sophisticated investors into Microsoft Excel, and seeing his Google Spreadsheet I’m going to extend that thought to include all cloud-based spreadsheet applications. In the model he shares, he has invested $50k as part of a $500k round in a startup. In his final scenario, he sells the company on the downside for $1 million and somehow gets back $164,167. 16% of the total returns! How the heck is he going to do that when he only put in 10% of the initial investment? Are the other investors in the $500k round going to say, “Hey Gabriel, you get paid first and we’ll just split up whatever is left over?” No. They are going to split the proceeds up according to the % of preferred that was invested, giving him a max of 10% of the return – i.e. he invested 10% of the initial investment so he’ll only get back 10% of the proceeds, since 100% of the proceeds are going to the investors in this scenario.
I present this as a compelling reason to get unsophisticated angels back into investing in converts.
Update: I was too harsh in my original post. I’ve had an email communication with Gabriel and I think he’s trying to do what is best. I also think he’s trying to help companies grow. His post was intended as a “hey I want to hear people’s opinions” and was not a license for me to be nasty. I was mean spirited in my original version of this post, which isn’t cool. I’d like to apologize to him.
I do very strongly believe that liquidation pref’s are an area where it is easy for entrepreneurs and investors to get out of alignment. I think that strong belief carried over into a morning where I didn’t have my usual cups of coffee at home (due to the boil water order here in Boston). To be clear, while I do think there are times when a multiple liquidation pref works for everyone (see my point one and two above, plus for some growth stage investments) I’m not a fan of it for seed stage investments where the startup will be likely to seek further funding.
NorthBridge, a well known Boston and California venture firm is sponsoring a seed competition. Details below:
NorthBridge’s new seed investment competition
I got this email from a friend at NorthBridge about a new seed competition that they are putting on. I don’t love the right to invest clause, but the $50k investment is a real amount and could potentially help a group of younger founders get their company rolling. See information in the document below; I am not affiliated with the competition or VC so you’ll need to follow the directions at the bottom of the page to get more info on the competition and submit your idea.
Jason Mendelson has a thoughtful post on why he thinks efforts to harmonize the current plethora of template seed investment funding documents will come to naught. His main point is that getting everyone to agree is an exercise in herding cats and that Brad Feld is going to beat his head against the wall trying to get people on the same page. He’s probably right, although I have found Brad to be a pretty charming guy, so who knows, maybe it is possible.
But who cares?
I don’t see another standardized set of deal documents as solving any real problem.
As an entrepreneur/former VC I see three main goals of standardized deal documents:
- Reduce the time required to raise capital
- Reduce the legal cost of executing a deal
- Make it easier to execute follow on investments by not making a silly mistake/term in your fund raise
Here is why a standardized set of seed documents doesn’t really help the entrepreneur.
- It’s going to take the same amount of time to get a deal done. Did the NVCA standard deal documents for Series A investments reduce the 30 to 60 day time frame it used to take to close a Series A deal (from signed term sheet to funding) NOPE. It still takes the median deal 30 to 60 days to close. (See my next bullet on how it takes the same amount of billable legal time to close a deal even with the standard documents.) Seed investors are the same way. Some will write a check fast, others take their own sweet time. This time frame is not driven by legal, it is driven by the individual investor. It’s not going to change with another set of standardized docs.
- Do Series A deals legal fees cost less now that there are the NVCA standard documents? No. Costs have probably gone up. Closing an investment takes pretty much the same amount of legal hours as it always has. Why? Because the cost of having a crappy lawyer work on your Series A deal is too high, so entrepreneurs and VCs go with the best/most expensive lawyers they can find. And the best lawyers need to “add value” so they fight over every random point, because there is that one in a thousand potential circumstance where it will actually really matter. And thus that is why they are good lawyers, always thinking of potential future issues and trying to protect you. And so it’s freaking expensive since all their thinking and arguing time costs a ton per hour. Anyway, the main point is that standardized Series A documents have not reduced the typical legal bill for a Series A transaction and I just don’t see them reducing the legal bill for the typical angel investment. The MO of the investor you go with will determine how much legal effort goes into your fund raise, not the documents you choose off of which to base your deal.
- Finally, if the goal of the seed documents is to make it easier to raise your next round of funding I think we are already there. (of course, consult your expensive attorney don’t rely on my legal advice.) Any of the currently existing standard seed templates listed by Jason in his post are probably good enough to not blow up your next round of financing. You are much more likely to have your next round destroyed by a difficult personality (either a difficult seed investor not agreeing with something next round investor “needs” or a next round investor insisting on something “impossible” for a seed investor to sign off on) than by something odd in one of the already existing standardized seed term sheets. In other words, the difficult personalities I’ve just cited just as likely to fight over any random term anyways, so one set of standard docs vs another doesn’t really matter. Oh yeah – don’t take my legal advice when negotiating/drafting your deal documents, talk to your experienced lawyer; did I mention that yet?
I think that the legal costs associated with closing a private fund raise are always going to be nuts. The only thing that I know for sure will make it less costly to raise seed funding is to get an investor who is laid back. It really seems like a personality thing to me, not a standardized legal document thing. If investors really want to help entrepreneurs and make it easier for startups to connect with qualified investors. Something like what Venturehacks is doing with their AngelList.
When I was a VC, I found the hardest part of the job was delivering the tough message of “no” to entrepreneurs. Nobody likes saying no, and it’s very hard to hear when you are invested in idea/company. Stuart Ellman and Jim Robinson of RRE Ventures have just published a good post highlighting some of the difficult messages they have to deliver. It reminds me a bit of the “you are the problem” post I did when I first left the venture business last year. Stuart and Jim’s piece is worth reading if you are curious to understand some of the issues VCs face when delivering tough news to startup executives.