Startup Toolbox

Jay Parkhill May 29th, 2008

This is one of the hardest questions to answer. There is no “right” answer to be sure, but here are the considerations.

1) Raising money costs both time and money. It takes time away from other things (it is not uncommon to see revenue dip during a financing since attention is focused on the investment instead of sales), so you don’t want to do it often. Legal costs are also considerable.

2) On the other hand, raising money involves dilution. You don’t want to raise too little because you don’t want to have to do it all over again soon. You don’t want too much, either, lest you dilute your ownership more than necessary.

One rule of thumb is to seek enough cash to last 18-24 months. This allows a decent amount of time in between financings, both so that no one needs to think about the next round immediately- and so that everyone can get a sense of where the business is headed before diving into another set of negotiations.

All of this is really preamble to a fascinating hint of a different model I saw this morning. Sapphire Energy announced a $50M “open checkbook” financing that allows the company to draw as much money as it needs to commercialize its technology rapidly.

What does this mean and how is it different from a standard financing? At first blush it sounds more like “venture debt” where a company takes a line of credit from a bank and agrees to repay it in cash and/or equity, but Sapphire’s investors aren’t known for making those kinds of investments.

I am going to poke around a bit and see if I can come up with some more information on the terms of the financing. What was the valuation? How is management/founder dilution calculated? Is it less if the company doesn’t need all $50M over a set period of time? What if Sapphire needs more than $50M?

Truly new investment models are rare. It will be interesting to see what this one actually looks like.

P.S.  Sapphire’s business sounds terrific as well.  A highly scalable crude oil-like substance from algae.   Neat.

• Financings

Jay Parkhill May 27th, 2008

I wrote a post on Gigaom over the weekend that covers the basics of a VC investment term sheet. A couple of the comments wondered whether preferred stock screws the founding team by definition. Another comment there answered the direct point pretty well (preferred stock is just part of the process). Fred Wilson’s post from this morning covers the philosophical angle as well and is worth reading as a complement to the mechanics I spelled out.

To paraphrase him- and dig under the surface of his comments a tiny bit- a VC’s job is to take risks, and so is a founder’s. The founder takes a chance with his idea and livelihood. The VCs risk someone else’s money- and in the process her own livelihood as well, because if none of her investments pan out she is going to be looking for a new line of work.

The VC may also be very active in a business, but not on a day-to-day basis. Ultimately, a VC’s job is to give an entrepreneur some tools to build a company, but the VC has only so much control over how (and how well) the tools get used.

Preferred stock helps line up the relative risks given all of these factors. As a friend of mine put it even more simply, preferred stock offers a mechanism to ensure that if things go poorly, morale runs low and everyone starts to wonder when to throw in the towel, the people actually running the company on a day-to-day basis will feel more pain than the investors.

Sometimes this is enough glue to keep the whole thing together and sometimes it isn’t. I have seen cases where a company has failed and investors have given up some of their liquidation preference so that founders can get *some* cash back. I have also seen preferred stock terms used to enrich investors at founders’ expense. There is no magic about any of it. Cheating and fairness are a function of the people involved; preferred stock is merely the framework on which the VC investment process is built.

• Financings , VCs , preferred stock

Jay Parkhill May 7th, 2008

Todd Vernon is the CEO of Lijit and wrote a post this morning that covers all the bases in angel financings.

http://falseprecision.typepad.com/my_weblog/2008/05/angel-financing.html

I won’t rehash the whole thing, but will comment on a couple of points.

Todd’s analysis of the different types of angel investors is very insightful.  In my ten years of experience advising startups, the family investor class is the most common type, but the companies that are unable to broaden their investor base beyond that seldom succeed in raising further money.

The analogy to burning cash is a good one, though I usually use winning the lottery to make the same point.  Startup entrepreneurs should be aware that at least on some level investment in a brand-new company offers about as much hope of return as lighting cash on fire, or spending $25,000 on lottery tickets.  No one makes that decision lightly.

I mostly agree with Todd about convertible note financings, with a couple of qualifiers.  First, no company should offer convertible notes if it doesn’t intend to convert them.  Todd seems to say that some people might undertake note financings intending to pay them off in cash rather than equity.  That is a terrible strategy and borders on abusive.

Second is that I have done successful note financings.  In almost every case the Note investor(s) are also participants in the equity round and are using the Notes as a genuine bridge so that the company can get some cash while completing the steps to a larger investment.  Notes usually come with warrants or other discounts from the equity round so there can be tension between the Note investors and the equity investors.  Having the same people on both sides of the deal helps immensely to smooth that out.

Good post Todd.  I am going to send a lot of clients to read your summary.

• Financings , Startups

Jay Parkhill March 21st, 2008

Here is a thoughtful post on raising money from angel investors. Author Charlie O’Donnell points out that it is really the same process as any other kind of networking- get out and meet people in your space and over time you will develop the kinds of trust relationships that faciliate investment.

This is going to be BIG! - The Secret Life of Angels: Raising an Angel Round for Your Startup

The problem I have seen many people run into is finding a great idea for a business and then trying to find the capital. Occasionally it works. So does looking for relationships in bars, but the odds are better if you aren’t going at it randomly.

The companion to this is the advice from Jeff Clavier and Brad Feld about making sure your investors are accredited. Everyone says they are accredited and as long as the company does well everyone is happy. In the worst case burnout, though, unaccredited investors put the burden on the company to say that risks were properly disclosed.

• Financings

Jay Parkhill March 18th, 2008

The headline from VentureBeat captures the spirit of the times just about perfectly.  Meebo, the IM-in-a-browser company that is "starting to focus on making money" is looking to raise a chunk of change at 4x the valuation of its last round and pegs itself as worth a quarter-billion dollars before that happens.

Meanwhile, Bear Stearns earned $233M last year according to its 10-K filing(and $2.3B in 2005 and 2006- oops) and was scooped up by JP Morgan for 1x last year’s earnings. 

It’s going to be a strange year.

Meebo raising round, valued up to $250 million. Bear Stearns sold for $236 million » VentureBeat

• Financings

Jay Parkhill November 8th, 2007

In Founders at Work, Joshua Schachter advises new entrepreneurs to keep the product simple- do one thing and do it well, in essence. This strategy worked well for del.icio.us, which is a simple (in a good way) web tool. He built it largely on his own in his spare time while working for Morgan Stanley and that setup worked very well for him.

Mike Ramsay from Tivo, on the other hand, developed an extremely complex product (I found great humor in the section of the book where he describes the enormous back-end efforts to manage programming information for every TV service in the US, and then explains why he feels compelled to throttle anyone who describes Tivo as “like a digital VCR”) that required enormous engineering, marketing and other resources. Tivo raised significant money from VCs and went public to raise even more. Again, this has worked well for Tivo.

This pattern also reminds me of the Dick Costolo/Marc Andreesen online debate about raising outside capital that I continue to see discussed from time to time. Dick built Feedburner with a relatively small amount of outside cash, developed an excellent product with it and sold the company to Google for a solid return. Consequently, his advice to entrepreneurs is to raise enough capital to allow for a good return for founders and investors even if the business is not a home run.

Marc, on the other hand, has built two large businesses and sold each of them for over $1B- two grand slams. Both companies were heavily VC funded and Marc believes that the cash gave both businesses the wherewithal to survive difficult times, revise their business plans and ultimately become very successful. Based on his experience, then, the advice is to raise as much money as possible whenever it is available on acceptable terms.

All of these companies and people were successful, which means all of them are correct. Del.icio.us and Feedburner needed only modest capital to acheive their objectives. Tivo, Netscape and Opsware needed far more.

This brings me back to a piece of advice I picked up years ago in an entirely different context. Professional cyclist Greg Lemond wrote a book on cycling training in which he talked about one of the great fallacies of training- emulating someone else’s habits just because the person was famous or successful. As he put it “what works for ___ is good because it works for ____. That fact that it worked for ___ doesn’t mean it is right for anyone else.”

In other words, the paths to success of others are valuable for the ideas they can provide, but they are not the “right” path for everyone. Past experiences are data points to analyze, not prescriptions to swallow whole.

• Financings , Startups , Tips & Tricks

Jay Parkhill August 28th, 2007

I’m a little late jumping on the bandwagon about Keith’s post, now two weeks old. The logic certainly makes sense- as one type of investment loses some luster another becomes more attractive (again). I didn’t post on it earlier largely because it was so well covered elsewhere I didn’t see a whole lot to add.

But then I realized I was wrong. I have two clients raising money right now, and both have had conversations with prospective investors who are really excited about the company, but loath to give up short-term gains they see markets delivering in the next few months.

As short as the timelines can be for tech-companies to start-up, build-out and exit, it’s still hard to convince an investor he should let his money sit idle in a company’s bank account rather than generate real cash in a six-month timeframe. Startups are risky, for sure, and even in the best cases the return is 1-2-3 years out or more. It ends up something like trying to convince the investor that two birds in the bush really are better.

I’m looking forward to seeing Keith’s prediction to come true and for “hedge fund fever” to abate a bit. The calculus is still skewed toward the short-term gains savvy investors can make; when a little more of the shine comes off the apple I am hoping that investors will be more comfortable balancing “longer term” tech company bets with shorter market-based approaches.

• Financings , Startups

Jay Parkhill June 29th, 2007

Plenty has been written recently about newish sites avvo.com and thefunded.com. Each seeks to add a layer of transparency to the otherwise murky-seeming fields of law and venture capital by listing people and firms and providing a rating system.

I think the idea behind both sites is good, though I am sure that there will be inequities in rankings, re-working of the systems etc. What interests me more is why people have chosen those two fields to cover.

Someone once pointed out to me that picking a lawyer is like choosing a car mechanic. Unless you are one yourself you don’t really know what they are doing. Even if things work out well you don’t know if it’s because of something your lawyer/mechanic did or in spite of it. You really only know if they screwed up.

And in fact this applies to every service profession, from accounting to x-ray technician. So why did lawyers and venture capitalists get chosen to be ranked?

My guess is that they are seen as gateways to cash. VCs invest it, of course, and the stereotype is of an insular group that makes decisions based on criteria few really understand. Business lawyers can provide introductions that help companies get cash or otherwise move the business forward. Litigation often works around the idea that cash should be in one place and not another as well.

This probably isn’t a huge revelation to anyone. It’s interesting to me, though, that I haven’t seen any similar services for doctors. Health is important, right? Wouldn’t it be useful to know if a doctor you’d been referred to had a good reputation?

Maybe this service is out there and I just haven’t seen it. If anyone has seen a doctors’ ranking site, please let me know in the comments.

• Financings

Jay Parkhill April 26th, 2007

Steve Poland is a bright guy with an interesting business idea at webothlike.com. More interesting is that he is blogging the entire startup process and seeking active input from the general community along on the way. I am one of his advisers.

Early in the process Steve was trying to figure out how to get started, and we talked about ways he might be able to bring in some early cash. Almost everyone- Steve, the public and me- agreed that it would be a lot easier to get the $20,000 he needed if he could sell shares to his readers.

Unfortunately, US securities laws were the holdout. They say that anyone who wants to solicit money from the general public needs to do so via the expensive, highly regulated public offering process. Private securities offerings must be just that- private. Publicly offering to sell securities, such as through a blog, automatically strips away the ability to use private offering rules.

i was intrigued, then, when Steve told me about Cambrian House. That company is using the wisdom of crowds to solicit its own set of business ideas. The twist is that for every idea submitted, participants get a “share” of Cambrian House stock. I signed up to test it out and now have a share of stock listed in my account.

Being a securities lawyer, I wondered how the company does this. They recently put up an FAQ that explains in part.

The FAQ says that a separate entity, Cambrian House Coop, has a right to 1% of the Cambrian House equity, revenue and/or dividends (the text is a little unclear). This leads to a couple of thoughts:

First, the economics. 1% of a company is not a whole lot and my share is a tiny fraction of that. If the company becomes worth $100,000,000 the entire program will have a value of $1,000,000, which must then be divided among as many thousands or millions of people as register and earn shares. So this is a neat gimmick but I’m not sure the reward matches the effort. If I kill myself to crank out more ideas than anyone else I may end up making a few tens of thousands of dollars between now and whenever the company is sold. Neat, but I won’t cut back my day job to work at it.

Second, the mechanics. Crowdsourced program participants will not actually own a piece of Cambrian House, but of the Cambrian House Coop. Participants will be entitled to elect the Board of Directors of the Coop, whose role is to determine how shares are distributed. So participants own no part of Cambrian House itself, but of the related entity that exists solely to help distribute 1% of whatever money Cambrian House decides it has made. This seems like an incredible amount of effort to distribute a relatively small amount of money.

This isn’t meant to be a criticism of Cambrian House. They seem to have a lot of faith in the wisdom of crowds and are simply trying to extend the financial reward to the people that make it all possible.

It’s not a critique of securities laws either. Their purpose is to help make sure that investors receive enough information about a business to understand what they are getting into before they sign on.

Unfortunately, these two concepts sail right past one another. Crowdsourcing is based on the idea that aggregating the ideas of communities increases value for everyone in the aggregate. Securities laws worry that any single individual might not have the resources to make a sufficiently educated decision.

It might be fun if Digg-style ratings could be used to help determine a business’s investment worthiness and the public could rely on that. We are definitely not there yet, though and probably never will be, so for Steve, Cambrian House and everyone else there may always be an imbalance between the benefit a company can get from the community and the equity value the company can give back to individuals within that community.

• Financings , Securities , Startups

Jay Parkhill November 10th, 2006

It doesn’t really break any new ground, but here is an interesting calculator that shows how Charles River Ventures’ QuickStart program might work.
The calculator is set up to demonstrate returns, so you can plug in different numbers for the amount of the QuickStart loan, the amounts of each subsequent fundraising round, and the exit valuation. The calculator then spits out the return to the founders and each set of investors.

This is interesting, but pretty long-term and hypothetical. I would be more interested to see a calculator that shows the effect of the QuickStart loan on a company’s cap table. E.g. how much of the company can founders preserve for themselves by using a QuickStart loan instead of a larger funding round?
I have done a million of these for my clients and thought I could try to add to the general base of knowledge here. I have no idea how to make an HTML calculator, but here is an Excel file that does the job.

The scenarios can get very complicated, but the basics could be expressed pretty simply. The main variables are:
*amount of initial loan
*amount of Series A round
*valuation at time of Series A (or percent of company sold for Series A funds)

The calculator could then spit out alternative cap tables showing founder/investor ownership percentages. One column would show ownership structure under the QuickStart model and the other would show the ownership assuming a larger VC financing. The value of the smaller, earlier financing should become readily apparent.

I made a couple of assumptions in the calculation, esp that the “VC funding” route would be for 1/2 the amount of the QuickStart Series A, and at 1/3 the valuation. Reasonable minds may disagree on the numbers, but the concept is that the target company would not need as much money in an earlier VC funding, and that the valuation at which the money comes in would be significantly lower.

• Financings , Securities , Startups