Startable - Healy Jones’ & Prasad Thammineni’s Blog

When you are an entrepreneur trying to build a product at a startup, you are in a pretty risky place. Usually you are not generating cash flow, you don’t yet know exactly which features are going to be required by the marketplace and you aren’t yet sure how you are going to market/sell the product (i.e. haven’t gotten product-market fit yet.)

Startup founders often see raising venture capital as a way to mitigate the risk of starting a business - basically, they get to play with the VCs money while they work out how to create a real business/get the product working. Having a salary is a great risk hedge (vs. no salary and working only for equity upside); a salary sure beats working for a couple of years w/o cash flow! If you spend the venture capital wisely, then you get to increase your cash burn to more quickly hit your target market and get your product to market. This is pretty much the thought process we had at OfficeDrop when we raised a modest amount of capital. It was becoming onerous to not get paid a salary, and we wanted to invest money in product development and marketing. And in our case, so far so good!

I recently read a post by Fred Wilson on CAPM, which describes the trade off between return and risk. There was a great comment by somebody named Julien, “I would love to hear about the current beta in the venture ecosystem. My bet is that it’s always very high, which induces stress for the VCs themselves, that they tend to transfer down to the startups in which they invest.” In other words, can VCs actually increase the risk of the startup? I believe that they can.

Venture Capital can make a startup riskier

How can this be? I want to make it clear that this is not usually the case - most VCs are actually helping derisk their startups’ business models. But raising money can make a startup more dangerous (for the founder in particular.)

The biggest way a VC can increase a startup founder’s risk is by not participating in a follow on round of financing. As herd animals, VCs look to each other for signals. An existing investor not investing in a subsequent round is a major red flag that something is wrong with the business. That’s why I’ve always recommended syndicating your Series A Round - you decrease the likelihood that no existing investor steps up. (Note that I have ignored my own advice with OfficeDrop.) There are other reasons that a venture capital firm will not invest - such as the fund running out of money or the partner who made the original investment leaving the fund.

IT Venture capitalists usually like to invest in “product” businesses - by product I mean businesses that generate revenue by selling something this is not based on billing out a person at a particular rate. I’m not describing this well, but VCs generally don’t like body based businesses that scale only as people are added (people who get billed out). But contrast this with a business that starts as a service and creates a product based on its own or its clients needs. A service based business can be profitable from day one for the founder, generating cash to pay the bills and cash to iterate to a product that the market wants. Great examples are 37Signals or FreshBooks (I know there is a great interview w/a 37Signals founder about why he doesn’t like VC, but I can’t find it this morning). Think about what would have happened if the initial products they created had flopped. If they had no venture capital, then they would have gone back to having great consulting businesses and maybe would have tried again later to create another software product. But if they had raised VC, their investors would not have been happy with them going back to having a couple of person business that looked like it could generate a couple hundred thousand $ in consulting revenue for the next few years - they would have insisted in putting massive amounts of development dollars into finding the next idea, even if the founders didn’t have a great one at that moment.

VCs also invest money with a pretty specific purpose - to build a company along the investment thesis the founder pitched initially. But if the initial product idea is failing, it becomes the founder’s responsibility to convince the investor that a pivot is needed. A good VC will act as a smart advisor, working with the founder to assess the situation and helping the founder find the right ways to pivot. The best VCs make introductions to potential customers before and during a pivot so that the founder can get smarter before the jump. But a VC may slow down the pivot, trying to get the founder to spend more time and money on the initial thesis. This can happen for a variety of reasons, but some of them may not be transparent to the startup. In particular, if the VC is having to play politics at his/her fund, they may not want to have to go back to the fund’s partnership and admit that their initial thesis was a failure. For a lot of startups, the road to success is paved with a series of small failures (i.e. learning experiences). Hopefully your VC does not mind these road bumps to victory.

Once you’ve raised a lot of money, there can be pressure to spend the cash. Even VCs with a lot of patience want to see their portfolio companies working hard to build a business. Everyone, from VC to entrepreneur, wants to see progress between board meetings. Recently I was hanging out with an executive of a locally funded startup who just admitted to wasting close to $100k on an Adwords campaign that she knew wouldn’t work. Having raised a significant sum of venture funding, the startup is getting pressure from the investors to spend the money to ramp up sales. Because the investors had experienced success with Adwords at a different portfolio company, they aggressively suggested a serious Adwords campaign. However, this particular startup’s space had very expensive PPC, and the basic math of generating positive ROI from Adwords just was never going to be there for the company. VCs need to see growth to justify their investment. I prefer to spend a little money and take a little more time to succeed or fail in my marketing efforts. Many VCs will prefer to spend big to determine failure fast. I’m not sure how much of your company you give up for $100k, but it’s probably a decent percent coming out of the founder’s pocket. Have a good conversation with your investor prior to the investment to make sure you are on the same page in spending the cash.

Venture capitalists make their money with big exits. For most VCs, making two times their investment is not considered a great use of capital. This means that VCs pressure companies to go big, which can destroy a great little business. As I talk about in my post “Don’t Raise Venture Capital,” make sure your goals are aligned with the goals of the investors before you raise money.

Venture capitalists can sometimes push out a founder. Fred once again has another great post, this one on parting ways with a founder.* While this may or may not be good for the startup, it does mean that the founder who gets pushed out will probably no longer vest equity. Since you are no longer working for yourself when you raise venture financing, you can increase your own personal risk if it is decided that you are no longer needed at the startup.

I’m not suggesting that you don’t raise venture capital for your startup. However, I don’t know if most founders consider the baggage that comes along with a check from a venture fund. The right venture capitalist can really help grow your business - but make sure you and your team are ready to go big when you bring all that cash onto your balance sheet.

*Note that I agree with Fred’s thesis; sometimes an early founder can be bad for a business as it grows. I can think of one example where the employees hated working with one of the co-founders of a startup because the co-founder was pretty much a jerk. When you lose great engineers because one of your co-founders pisses off everyone he interacts with you’ve got a problem. I’ve also seen a situation where one of the co-founders started spending a lot of time not working, which really de-motivated the other founders and engineers who were working 80+ hours to launch the product. If someone decides to no longer pull their weight, why should they continue to get paid and own a big % of the business - especially when it is a fresh startup that was just recently founded?

Good news for the New England early stage startup community - venture capital investing rebounded from last year’s lows. $789 million in VC was invested in New England in Q1 2010 vs. only $408 million in Q1 2009. This is a significant pop, and gets us closer to the 2008 and 2007 totals of $872 and $984 million. I’ve pasted in a couple of charts from data I took from the spreadsheets posted on peHUB.

Overall, peHUB says:

Venture capitalists invested $4.7 billion into 681 U.S. companies during the first quarter of 2010, according to MoneyTree data released today by PricewaterhouseCoopers, the National Venture Capital Association and Thomson Reuters (publisher of peHUB). This represents a decrease in both deals and dollars from the preceding quarter — by 18% and 9%, respectively — but an increase over the first quarter of 2009.

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:

1. Reduce the time required to raise capital
2. Reduce the legal cost of executing a deal
3. 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.

1. 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.
2. 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.
3. 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.

Congratulations to Mike, Bruce, Sandro and Bill of DataXu for raising a Series B investment from Menlo Ventures, a well known Silicon Valley venture capital firm. Atlas Venture and Flybridge, the Series A investors, invested in this round as well. I got to know the DataXu team when I was with Atlas and worked on the Series A investment. Mike has a great team and some solid technology.

I think it is great that important West Coast VCs are making follow on investments in the  Boston area - another prominent investment like this is Scale Ventures investment in Hubspots most recent round. When Boston companies are doing well enough to attract capital from outside the region then you know something good is happening.

Also important - while Boston may the the number 2 venture capital pool in the world, it is nothing compared to the capital available in Silicon Valley. When venture firms from San Francisco supplement local New England funds this means that there is more early stage capital available in the region to support innovation - a really good thing! Let’s hope for some more great companies like DataXu and Hubspot. Actually - let’s try to make them ourselves!!!

Inc has a solid piece on terms to be careful of when raising venture capital. I spent some time on the phone with Darren Dahl, the journalist who wrote the piece, and he did a very good job getting his arms around some of the most important issues I’ve seen entrepreneurs trip over. Raising a venture round is very difficult and confusing terms are one area where VCs have a distinct edge over entrepreneurs. This Inc article is a good resource for founders trying to understand the terms presented to you by a VC.

A good venture capitalist will walk you through the terms after he/she has presented you with a term sheet. You should ask for this if it is not offered to you after you get a term sheet. You should prep with your lawyer prior to this and ask a lot of questions of the VC as they go through the terms with you.

And, while they are really expensive, get a good lawyer for your fund raise!

And this is before the Nexus One!

Today I use a ton of applications on my iPhone to get the full experience of online services/sites like Facebook, Amazon, LinkedIn, Wikipedia and others. But the beauty of the web (at least on the PC) is that you don’t need to download software in most cases to get a full, awesome experience. I can just log into eBay and start trading stuff; I don’t have to wait for a download to get going.

But on the mobile phone it’s different. To get the best experience I need to hit the app store and download something. It’s a like a weird step backwards from the point where anyone could easily use any site with a browser (from your PC) without downloading software to a place where each site has its own special software that requires a download and install.

According to MediaPost:

Gartner estimates the combined installed base of smartphones and browser-equipped enhanced phones will surpass 1.82 billion units by 2013, eclipsing the total of 1.78 billion PCs by then.

But the firm warns that many sites still are not optimized for the mobile Web, even though cell users expect to make fewer clicks on their phones than on a PC. To successfully expand into mobile, publishers will have to reformat sites from the small form-factor of handheld devices.

I totally buy this argument. While one can quibble around the exact number of mobile devices vs. PCs, there is a clear and obvious trend that mobile devices are becoming an important secondary, and to a lot of people, the primary web access device.

So I wonder - will web sites just automatically be optimized for mobile viewing, or will the “app” become even more important? Is this whole app thing for using online services a real of “de-evolution” of the web - or a mere blip before mobile browsers and bandwidth become powerful enough to support the real web experience? What do people think, are mobile web apps here to say or just a strange passing fancy?

Great interview with Don Dodge, tech luminary who recently joined Google from Microsoft. Don was technology ambassador for Microsoft and is now in a similar position at Google. Don has a very unique view into both companies strategies, technologies and cultures. Some of the best quotes:

One of Google’s biggest challenges: “Another challenge is to earn a reputation for communicating clearly with developers and partners, providing them the support they need, and being as clear as possible about our product road map. ”

On how Google is prioritizing its efforts vs Microsoft: “All the exciting new applications are running in the browser, with application code in the cloud and the cell phone as the platform… Microsoft has product offerings in each of these areas, but they weren’t the high-priority programs… At Google, Chrome (browser), Google App Engine and Google Apps (cloud), and Android (mobile) are top priorities…”

On the state of MSFT: “I think Microsoft today is a lot like IBM was in 1985.”

On the cloud: “It all comes down to your application needs, workloads and design architecture. Amazon, Google and Microsoft are all solid choices.”

It’s a great interview; check it out.

It’s great news that Laura Fitton’s oneForty has received venture funding, in Boston, by Flybridge Capital. I’ve blogged about oneForty being one of the most exciting companies coming out of TechStars Boston this past summer, and it is great news for the local New England internet scene that oneForty has been funded by a local firm.

I had a bad feeling that oneForty would move West, as Laura had good angel funding backers from the SF area. She also was working closely with a web design firm base in SF. Of course, the major thing that had me scared she’s leave Boston was the recent ZenDesk move - cool company leaves Boston after it gets funding from a West Coast VC. But Boston was in luck! Jeff Bussgang of Flybridge had the cojones to step up and keep this cool company in New England. Good luck with the investment Jeff and good luck to Laura as you grow the business! (Also, congrats on recruiting Sachin Agarwal to the team and bringing a talented internet entrepreneur to the area from Chicago.)

I’m going to do something out of character (and off topic for this blog) and complain about Wall Street. I started off my career as a baby banker before moving into venture/growth investing, and think I know a bit about the people on Wall Street. My thoughts here stemmed from a recent post I saw about several important bankers missing a “chat” with the President. I’m not really faulting the bankers for missing this meeting; there was bad weather and their commercial flights were canceled. Although, I will point out that, when I was a banker intern in NYC I once had to take an overnight town car from New York to DC to deliver pitch books because the senior bankers were afraid that bad weather would keep the associate on the deal from making the meeting. And they were right. And the senior bankers also had the courtesy to fly in the night before to avoid potentially missing the meeting with the important client. But I understand not needing to fly down the night before to make the meeting with the President. After all, he’s not really a client or anything.

But that is not the point of my piece. Rather, I’d like the point out the problem with Wall Street.

The problem with Wall Street

Wall Street is full of people who really, really want to make money.

In some ways this is a good thing. It provides a place for people who want to make money to do so in a legal fashion. It’s kind of like the way the Marines provide a legally valid profession for people who really like to kick a** and take names and blow things up.

But it also leads to some issues.

One, Wall Street will gladly take money from your grandmother. If grandma is silly enough to make a bad trade in a complex security, then she deserves to lose her money. Or, if grandma’s pension fund trusted some of its money to a money manager who is just not as smart as someone else, then grandma also deserves to lose her money. It’s too bad, but that is how it works. Although I’m not really sure how grandma is supposed to retire if there isn’t really a safe way for her to invest her money without sharks taking an unfair percentage of it.

Two, somehow incentives on Wall Street lost touch with the duration of the risks and assets bankers were creating. An annual cash bonus system doesn’t work if you are creating a security that might not show any problems for the next five to ten years. There is no claw back. Unlike PE shops, where partners can actually their pay taken back if their fund loses money, a banker (I’m not really sure why they are called bankers when they are actually traders/hedge fund guys working within a bank) - anyways, a banker gets paid at the end of the year for the actual and/or fictional appreciation of her trades. Imagine there is a trade (syndication, loan, whatever) that a particular banker could make that might result in her getting paid millions of dollars this year. Even if this trade has a small percentage chance of sinking the bank (or maybe even the entire financial system) why wouldn’t she make that trade? Her downside is limited to losing her job; her upside is unlimited. The NPV of that trade is very, very positive to her. Like the good little capitalist that I am, I always assumed that public stockholders, through the board, would ensure smart risk management and proper compensation of traders. But I guess I was overly optimistic, since shareholders lost billions and happy bankers still are getting nice bonuses this year.

I, for one, am glad that Wall Street exists. Money needs to move from industries of low returns and flow into places where it can create jobs and finance growth. I also like making money for myself and I don’t find anything morally wrong about wanting to make money.

I guess I sometimes feel bad about grandma’s retirement, but I’m not really sure how to protect her. And I don’t know how a bank is supposed to retain talent when that talent can easily leave the bank and go to another shop where it will get paid a ton in the form of annual bonuses based on short term gains. But something just does feel strange when grandma can lose her retirement, via no fault of her own, and very smart people on Wall Street can once again get awesome bonuses based on very short term incentive plans. It just feels strange.