Startable – Healy Jones’ & Prasad Thammineni’s Blog

Betaworks is another newer seed fund with a different model, as mentioned in PEHub. The group focuses on “new media” opportunities. They are really innovating with the structure of their fund – they are actually not a fund. Instead, they have organized as a company. It sounds like they want to be some sort of new media holding company, with some operations internal to the business (either by acquisition or by founding it internally) or by making seed investments in startups.

When making seed investments (as quoted in the PEHub interview) they “invest as little as $25,000, though our average is in the hundreds of thousands of dollars. We mostly join rounds that are a million dollars or less altogether, and we typically participate with early-stage investors that we work with again and again and again.” This is a great spot, as it is clearly underserved.

It’s clear that they focus on internet and online media companies, with investments/ownership of bit.ly, Stocktwits and Twitterfeed.

I think this is an interesting model. I kind of like it. Build it, buy it or invest in it. Pretty fun options.

I guess my one fear as an entrepreneur pitching to this group is, will they try to develop the idea on their own, since they have developer resources and ambitions of becoming a holding company? I’m assuming they will try to handle this sort of an issue like top tier VCs do, and try to avoid these types of conflicts – but it’s to say from their web site how they approach such competitive issues when evaluating investment ideas.

Their web site is not at all like the traditional VC or angel investment group. I appreciate all the cool stuff on the site, but it is a bit confusing to figure out what their thesis, check size and current areas of focus are.

Michael Greeley, Chairman of the New England Venture Capital Association (NEVCA) and Partner at Boston-based Flybridge Capital Partners predicts that New England companies will raise $2 billion in venture capital in 2010. That’s down from $3 billion in 2009. He points to the fact that NEVCA currently has 108 members, down from 138 members in 2009.

Yikes.

Hey startups… time to get really friendly with those angel investors who still have cash money!

Despite the existence of standardized term sheets from the NVCA legal fees continue to be a major cost of raising early stage capital. I always recommend getting one of the biggest and best law firms as your counsel during your fund raise, because legal mistakes can really hurt you and your startup. But good attorneys are very expensive. Remember that the venture capitalist will also have an expensive lawyer helping his/her fund with the investment, and they will ask you to pay for their lawyer too. So, when you get the term sheet from your investor you need to:

Make sure you cap your investor’s legal fees

It is typical that an investor ask for you reimburse their legal fees. However, many investors kindly forget to put the typical second sentence behind this provision in the initial term sheet that they give you. That sentence is something like “reasonable fees in the amount of up to $25,000 to Investor’s counsel.” You have ever right to cap the fees, and the typical cap is $20k to $25k.

I really wish there was an easier way to raise small amounts of capital, say less than $1 million, without expensive lawyers. But I have yet to find a really fair way to do this, and because the stakes are very high it makes sense for both sides of the negotiation to have good representation. I guess legal fees will always be part of a fund raise. I know I’ve complained about legal fees before, and will likely continue to do so…

Following up my post from yesterday on exciting seed funding developments in Boston, The Founders Collective is officially launched. At least, their web site is now up. I know they have been attending various tech networking events recently and the word was already out that they had money to invest.

More seed funds for Boston = better

Boston needs more very early stage investors, and this fund looks like it will help fill a very critical fund raising gap. From their stated positioning on their web site, it looks like they will actually address the biggest hole facing the Boston technology investment scene:

Two guys and a dog. Unless one of the three is Bill Gates, it’s hard to get funded here in the North East.  Believe me – I know from both sides of the table now. New England VCs (and many of the local angel groups) love supporting previously successful CEOs and founders, but are slower to pull the trigger on unproven talent. If the Founders Collective is really willing to step up and fund new startup talent this could be a real boon to the local tech scene.

Is this the new early stage VC model? Most of these partners have real, full time jobs as founders/leaders of their own companies. Doing the math, there is no way a $40 million fund could support this many traditional VC partners salaries w/o the expectation that the next fund(s) would be much larger. Since the Founders Collective states that they want to keep the fund size small, the expectation must be that most of them keep their day job. Since I am now all too aware of what it’s like to work at a very early stage startup, I should probably say “day and night job.” How are they going to be able to do this? It’s going to be a ton of work, but I hope that they are successful.

How many new investments can they reasonably make in a short period of time? I wonder how much involvement the full-time CEO partners will be able to make. Will it be a consensus driven fund, where each partner needs to agree to a new investment, or can a single partner push the funding button? I’ve got so many questions on how this will actually work. It’s quite exciting.

They also state that most of their investors are successful entrepreneurs who are hoping to be involved in mentoring the fund’s startups. This would be awesome. Every entrepreneurial community needs this sort of knowledge and experience sharing.

I wish the team at the Founders Collective good luck and hope that they are able to get some great companies going!

There was some great news this past week for the New England startup scene – TechStars recommitted to another season in Cambridge and The Founder Collective officially announced that they’ve got a $40 million fund to make early stage/seed stage investments in New York and New England. I’ll talk about the Founders Collective tomorrow, today I’m going to focus on TechStars.

TechStars is coming back to Boston!

I was lucky enough to participate in TechStars Boston this past summer. It is a great way to launch an internet company, with solid mentors, great media exposure and a super-crappy office filled to the brim with passionate + smart technology entrepreneurs.

I can’t emphasize enough how great the mentors were for the TechStars program. The companies that had the best experiences at TechStars were the ones that took advantage of the one-on-one time that different mentors offered. These mentors were people who have successfully built real technology businesses. They opened doors for the entrepreneurs by introducing them to distribution partners, technology experts, journalists, etc. They provided strategic and operational advice. They beta alpha tested the heck out of the companies’ products. You can’t get this level of mentorship anywhere else that I’ve seen – not from a venture fund, not from a school – no where.

My advice is to apply to the program if you are a young, first time entrepreneur who has a grea idea and the ability to get it going fast, for not a lot of cash. TechStars is accepting applications now, so get on it. Remember that they are looking for you to show traction with your business during the application process, so set developmental (and if possible customer acquisition) deadlines over the next few months, mention this in your application and hit them.

One of the greatest things about TechStars being in Boston is that it brings talent in from other parts of the country. TechStars recruits from everywhere, and some of the great entrepreneurs from this past summer’s program has stuck around.

The change from the summer to the spring doesn’t really surprise me, but I do wonder if this will cut out some potential student founded companies from the program. Boston does have great entrepreneurial-driven cultures at places like MIT, Babson and other schools. It will be hard for some of these students to commit to full time company-founding during the spring if they are supposed to be in school. I guess they could potentially take a leave but this is cutting it pretty close to the spring for some registrars’ offices I bet.

Great post by Mark Suster on when, if and how startup founders should be allowed to take money off the table before their starup has reached a real exit. Mark’s basic thesis is that it is sometimes a great idea for startup founders to sell some of their equity to their investors. He discusses his own experiences and suggests how he would have managed his own companies differently and/or not sold them when he did. His post is well reasoned and is worth reading. He does suggest a few scenarios where this makes sense and should be allowed, including the founder having been with the company for a certain number of years, limiting the $ amount to something reasonable, etc.

What I’ve seen is that early-stage VCs with big funds are not against buying common stock from founders, when the startup is doing well. As I’ve mentioned in my startup valuation post, VCs are always thinking in terms of their percentage ownership. When the company is doing great and VCs with deep pockets are already investors and want to increase their ownership, so if that means potentially buying stock from founders you may be in luck.

One of the other funds I worked for, Summit Partners, made a living off of buying stock from founders. It worked pretty well, since Summit liked investing in companies that were profitable and growing – and hence didn’t really need traditional venture capital to grow the business. Founder liquidity was the general excuse Summit used to get into some great companies.

I’m not at all against the idea of founders taking some money off of the table, provided the company is doing well and provided they continue to own enough of the company to continue to care about its success and work hard to keep it growing. I do think this would be a real advantage of selecting a larger sized fund as your initial venture capital investor. Smaller investors may not have the additional cash reserves available to both fund some liquidity and also continue to have enough in reserve to fund the company’s growth.

James Geshwiler, a local angel investor and a managing director of CommonAngels, has an interesting post in Mass High Tech entitled “Hey, Boston-area VCs, angels: Loosen up and connect with startups.” Besides the catchy title, James has a good point. I’ve debated this point with some of my venture capital friends, and I believe one of the most important roles of a VC – even if they are not invested in your company – is to help connect startups with others. Other startups, executives, potential customers, press and potential exits. This goes well beyond the whole recruiting-people-to-work-at-the-startup issue.

One of the things that somehow gets overlooked when the East Coast VC world is compared to the West Coast’s is how aggressively many of the most successful West Coast VCs promote their companies. And how aggressively the promote their companies to the RIGHT people – people who run companies that will one day acquire those startups, or buy their technology.

If you are a startup in the fund raising process, don’t be afraid to ask the venture capitalists for introductions. If you impress or interested the VC enough, they just might be able to connect you with the individual who will somehow help drive your company to success. It doesn’t hurt to ask!

The kind folks over at The Funded have created a template early stage term sheet that they believe will help make it easier for VCs and entrepreneurs to close Series A rounds with lower legal fees. This is very much a noble cause and I support the idea. Reducing friction and costs associated with a fund raise = great idea.

I’m not a lawyer (and as always I advise you to get a good one if you are negotiating with VCs), but if you can get a VC to agree to this term sheet at a valuation and $’s raised that you like I think you ought to accept it! This is a pretty darn entrepreneur friendly term sheet and you’d be feeling pretty good if you got a VC to sign it.

However, I’m pretty sure most VCs will push back on at least a few things, such as their preferred stock voting as converted instead of as a single class, the single trigger vesting upon acquisition (meaning the entrepreneur gets all their stock 100% vested if the company is sold), no redemption rights, some VCs will want full participation and finally I don’t see an exclusivity period in this term sheet. I’m not sure any VC that signs a term sheet without an exclusivity period really knows what he or she is doing. And they are probably going to have to ask you to pay for their legal fees (oh – you thought the term sheet was the expensive legal part of a venture capital round? It actually gets expensive when you are drafting the stock purchase agreement, the investor’s rights agreement, etc.)

Of course, if you need to raise a Series B round THAT investor may try to get different terms. And, if you use this term sheet and have issues further down the line remember that I warned you to get a lawyer to help you…

A guess the real question is, will there ever be a fund raise where the entrepreneur is going to be able to risk not having good (read: expensive) legal advice? Will it ever actually be possible to reduce the importance of sound legal advice when negotiating with VCs? A few years ago the NVCA published standard legal documents for venture capital investments. So far as I know, all decent venture capital firms base their investment documents off of these standard templates. But did this actually reduce the cost of legal advice on the typical venture capital investment? Has anyone actually looked at the average cost of company counsel pre-NVCA standard docs being published and post? I have not been playing this game long enough to know if this initiative actually saved anyone legal fees. My bet (and I have absolutely no data to back this up) is that entrepreneurs are paying about the same in legal fees today on a Series A deal as they did a year before the NVCA published their docs. So, even if The Funded or some other more standardized term sheet takes off I’m willing to be it will ALWAYS be a competitive advantage to pay up and get good legal advice on a VC transaction. You just don’t want to mess anything up when you first establish your capital structure…

One more thing: expect to pay around $25k to your company counsel and $25k to the investor’s on your Series A round.

Mark MacLeod pointed me to a recent publication by Fenwick & West (a well known tech law firm) on the increasing number of down rounds for venture funded companies. According to Fenwick, for the past two quarters, “down rounds” have exceeded “up rounds” when venture backed companies are raising follow on financing. To go into a little more depth here, a down round is when a company that has already raised venture capital raises additional capital (another “round”) at a valuation that is lower than the valuation from the previous round. In other words, the company is worth LESS than it was after the completion of its last fund raise. So, for the past couple of quarters, many previously venture backed companies are falling in value.

Why 2009 Q2 valuations are falling

The decrease in valuation for these companies has averaged about -50% for the past three quarters – a pretty hefty drop. This is probably caused by a few horrible issues converging all at once: 1) the NASDAQ is off by 30%ish from its two year high, and was at one point 50%ish off its high – obviously valuations for private technology companies are going to be impacted; 2) the difficult market conditions have made it harder for venture backed companies to achieve their goals and hit their value creation milestones, therefore many of them have probably failed to really move the needle on their valuation in the positive direction; and 3) there is less venture capital floating around, so as supply of follow on financing drops valuations should follow downwards.

The hidden cost of a down round for a venture funded company – anti-dilution provisions

The problem with a decreased valuation, from the startup founder’s perspective, is that the venture capitalists are going to significantly increase their ownership in the business at the expense of the company’s management team. Not only is the price per share that the VCs are investing in down (thus they buy more of the company) but they also will benefit from a standard term in venture capital fund raising – the anti-dilution provision.

The anti-dilution provision is intended to protect the investor in the event of a down round by resetting the conversion price from the VC’s previous investment(s) in the company. This provision resets (much like a “do over”) the price paid per share from a previous investment to the new price per share, or to a calculated price per share in between the previously paid price per share and the new, lower share price paid by the investors in the current round.

I’ll run through a quick mathematical exercise so you can see the impact of a down round on a company with a “weighted average” anti-dilution provision. This is the standard anti dilution provision, and is much more founder friendly than its less standard cousin,  the “full ratchet” antidilution provision.

For this example, let’s assume your startup has raised a Series A with the following terms:

$5 million from VCs at a $5 million pre-money valuation. This means the investors own half the company, and management owns the other half. Also, let’s assume that there are 10 million shares outstanding, so the investors own 5,000,000 and management owns the same. Thus, the price per share is $1.00. Post money, after the Series A, is $10 million.

The company needs another $5 million.

Up round – Say that everything is great, and the company is able to raise capital at $2.00 a share. Ownership post financing will be: Read the rest of this entry »

Venture capital firms with the most desirable addresses in the venture business – Sand Hill Road, Winter Street and the Big Apple – out perform VCs not located in venture capital centers. I’ve recently read a study produced by four researchers on venture capital as a local business that suggests that VCs located in the three US venture capital centers make better investments than VC firms based in non-venture capital hubs. (see my comments in italics at the bottom of this post for some discussion around the study’s methods.)

The study also suggests that venture capital funds actually seem to be more successful when they make investments outside of their home territory, despite the fact that VCs are notorious for preferring to invest close to home. The authors believe that because VCs are more hesitant to commit to an investment outside of their home turf then they raise the bar on these investments, thus becoming more successful when they make them. Additionally, it is possible that they face lower competition for deals in non-core venture markets. I can buy both of these arguments and would not be surprised if venture firms did better when investing in non-local startups.

The authors also reach another conclusion that I probably don’t agree with. They postulate that the superior returns delivered by VCs in SF, Boston and NYC are totally driven by their non-local investments out sided performance, “the out performance of venture capital firms based in the venture capital centers can be attributed to their out sized performance in investments made outside of the venture capital firms‟ office locations.” That is pretty hard to swallow. I’m pretty sure that many of the best venture capital investors make a ton of their returns from successful investments in their home regions. Local investments such as Sequoia investing in Google or CRV’s investments in EqualLogic probably drive more of their “success” than the sum of their other, non-local, investments.

One other interesting point drawn by the researchers is that the presence of a local co-investor does not raise the likelihood of success when a VC based in one of the venture centers invests in a non-venture hub startup. Many times, when a VC makes an investment in an area not close to home, they try to syndicate with a local venture firm. The theory is that this local firm can better help manage the investment, recruit talent local to the startup, coach management, etc. If I am reading the study correctly, these local firms don’t help the venture center VC. I guess this means that VCs based in one of the 3 hubs are just better investors than shops located in other areas?

So how does the reality of the venture capital real estate market impact the entrepreneur looking for funding?

But enough about venture capitalists. The more important fact to be drawn from this study is that it is easier for a startup to get funding if it is located in on of the three venture hubs. 49% of all VC investments were made in one of these three areas. If you are not based in a technology center and a venture firm appears to be interested, but asks, “where do you see putting the company’s headquarters,” or even more blatantly, “will you move the company to San Francisco after it receives funding,” you may seriously wish to consider indicating that you are open to moving the company. I understand that there may be reasons why this doesn’t make sense for your particular startup, but it will be much easier for you to get funded if you move.

Secondly, it appears from the study that VCs based in one of the 3 core venture regions are better investors than their less-optimally located brethren. This would suggest that startups not located in SF, Boston or NYC would be more likely to be successful if they take money from a VC located in one of these areas. This does fit in with some of what I observed during my time as a VC. We would often get referrals from funds not-located in one of those 3 markets looking for a syndicate partner for a particular investment. Many, many times these companies turned out to be “me-too” investments. By this I mean business plans that had already been beaten to death by Boston area VCs, but somehow still seemed like a good idea in a non-technology center. This is probably because the investors and entrepreneurs in those non-hub locations didn’t have the same level of access to deal flow as we did and so they didn’t realize that their idea’s time had come and gone. If investors in a hub area are saying that they’ve already seen your idea a dozen times then you should do a little more research into your startup’s competitive landscape.

A few things about the study:

This is a US focused study.

Success is defined as IPOs. This is a bit too narrow, but given the databases the researchers were using I understood why they did it. I don’t have enough data to decide if this makes the study meaningless. The vast majority of successful exits that I have seen have been exits through acquisition, not IPOs. However, I’ve only been an investor during a time when IPOs were not easy (since 2002, basically) so my viewpoint may be unfairly biases. The study looked back to 1975, I believe, so their view is much longer term than mine. They also can’t analyze differences in the level of success of an IPO – so Google’s IPO is as successful as an IPO for a company that later goes under. This is probably also a too great of a simplification, but I don’t know how they could do it differently given the databases they used. They also have tried to run the analyses again including the “merged of acquired” status in VentureXpert, but I do not believe that this part of the analysis is valid – in VentureXpert a failed company can be “acquired” by a larger player for peanuts. This happens often enough that I don’t think the M&A outcome in VentureXpert is a good measure of “success.”

Increasing the number of venture capital firms in a given CSA increases the number of new venture-backed companies. However, the SF Bay Area is 5x more productive in creating new venture-backed companies per venture firm than anywhere else. Also, regions with higher levels of “successful” investments spawn greater numbers of new venture-backed companies. This makes a lot of sense, given that entrepreneurs leave public companies and start businesses with their capital and knowledge, and that IPOs are inspirational to other entrepreneurs (and VCs) in a particular town.