Monday, November 14, 2011

Crowdfunding - Good Idea or Really, Really Stupid Idea?

Last week, the House of Representatives passed the Entrepreneur Access to Capital Act (H.R. 2930), commonly referred to as Crowdfunding. Since small businesses are responsible for the vast majority of new jobs, legislators believe that these new rules will make it easier for entrepreneurs to raise capital and ramp up hiring. In theory, this sounds like a great idea. However, in practice, this will be very bad.

I won't go into the details of the bill, but at a high level, it allows entrepreneurs to raise funds over the Internet up to a maximum of $1M annually (or $2M with audited financials). Maximum investment from each individual investor would be the lesser of $10K or 10% of annual income and investors do not need to be sophisticated. These investments would be exempt from registration under the 1933 SEC Act.

There is a reason the SEC exists. I can't remember if the SEC was one of the government agencies that Rick Perry wants to get rid of (but neither can he), but it seems like this is the exact type of investor that the SEC was set up to protect. Angel investments are highly risky and I would estimate that over 90% provide no return to equity investors. This is why 25-30 investments are required to achieve proper diversification as an angel. 10% of an individual's income is a very high amount and there will be many scenarios where non sophisticated investors will invest in multiple companies and going over the limit by simply checking a box in an internet form.

You may be thinking, "Ah, ProfessorVC is concerned about more competition in his angel deals". I like the way you are thinking, but not true! At the end of the day, very few entrepreneurs say "I wish I had raised less money"...and very few angel deals are truly oversubscribed, no matter what the press release says. More funding at the seed level is a great thing! Just not from investors who can't afford to lose the cash.

I often speak on panels and am often asked questions about what are the qualifications to be an angel investor. My response (only partially tongue in cheek), is to hold a $100 bill on one hand and a lighter in your other. Light the bill. Are you calm? If so, do it another 5-10 times. If you are still ok, then you are probably fit to be an angel.

Clearly, there are benefits to making it easier for entrepreneurs to raise seed funding. I'm an active participant on AngelList a fan of the excellent accelerator programs (YCombinator, 500 Startups, TechStars, AngelPad, etc.), and an investor in Right Side Capital Management (RSCM). RCSM is seeking to add scale to angel investing through a highly automated screening, evaluation and diligence process.

However, I'm just not comfortable with where this legislation is going. Crowdfunding will likely be well received by scam artists and lead to many startup investment pitches in your spam folder along with those for viagra and male enhancement. More importantly, this could lead us down the road we've already traveled with day traders and real estate flippers...At the very earliest stage, this is the realm of friends & family and if you are comfortable taking investment from your fraternity brother, not so rich uncle or brother-in-law, be my guest.

Monday, September 26, 2011

Card Counting for Investors

How would Billy Beane have done as an early stage investor?

I haven't had a chance to see Moneyball yet, but did read Michael Lewis' book when it came out eight years ago. However, I have seen some blog posts posing the question about whether the same principles of valuing baseball players could be applied to entrepreneurs.

Dan Frommer, in Moneyball for tech startups, interviewed Fred Wilson, Chris Dixon, Paul Graham and Ben Horowitz on the topic. According to Dan, the consensus "seems that this sort of technique is possible. And given that four of the most important tech investors in the world seem skeptical of it, if someone can figure out a good formula that works, they may be able to exploit it".

Well, I think I know the guys that can do it! I've written previously about Right Side Capital Management (RCSM), the latest in my post earlier this year, "How Much Diligence is Due..." (Full disclosure: I am an investor and adviser in RCSM.)

RCSM's premise is that they can reach an investment decision (and valuation) based on an application completed by the founders and take gut feel out of the decision process. Below is a short description of their philosophy:

"The part of our philosophy that makes us most different from other startup investors is that we don't believe gut feel is a reliable indicator of potential at the seed stage. Humans are just not very good at simultaneously integrating that much uncertainty to form a judgement. So we focus on specific aspects of a proposed venture that we can evaluate with minimal ambiguity. Over time, we plan to build increasingly sophisticated evaluation methods based on hard evidence."
I'm still not convinced that "gut feel" isn't a good way to invest at the early stage, but this can certainly get rid of over-thinking and provides diversification and investments in entrepreneurial teams that would be otherwise overlooked. They have launched a valuation tool that is free to try out. I encourage entrepreneurs to give it a shot and let me know what you think.

RCSM is also participating in the TechStars funding alliance that will be providing an offer of $100K in funding upon acceptance into the program. This will give RSCM the opportunity to test out their process on the large number of TechStars applicants.

Also interesting that some of the guys behind RSCM are professional poker players who have a deep appreciation for odds and statistics. In the trailer below, Brad Pitt in describing the new player acquisition philosophy, says "we are card counters at the blackjack table we're going to turn the odds at the casino"

I look forward to checking out the movie and seeing if RSCM can exploit the odds on early stage investing.

P.S. ProfessorVC is happy to have been included as one of the 50 Best Professor Blogs

Friday, August 26, 2011

Waah...Do I have to build a financial model?

I get asked this question a lot by entrepreneurs (and students). I often feel like a Dad (which I am to two wonderful teenage daughters) when I respond, "Yes, because I say so"...Everyone seems to know someone who has raised huge amounts of venture capital without ever putting together even back of the envelope projections. The objections range from "it's hard", "nobody believes them" to "all hockey sticks look alike". To that last one, there is certainly some truth as the standard time vs. revenue chart in most business plans looks like this:

I'm not teaching Entrepreneurial Finance this semester for the first time since Fall 2007. However, I am teaching the ELAB and a new experimental course (The Silicon Valley Experience) for the MBA program. Since I won't have the opportunity to lecture students on this topic until the spring semester, I'll share some of my thoughts here and perhaps can have a dialog on the topic. High level, building the financial model forces the entrepreneur to:
  1. Validate the concept and business model
  2. Determine financing needs and key milestones
  3. Build credibility with investors
I used to also argue that it supports your proposed valuation, but on an early stage deal that is a bit far fetched to get in to a valuation discussion based on your pro-forma projections. The importance is what is behind the numbers. How do you think? What are the key drivers and metrics? Is the model consistent with the business plan? Does the business model make sense? Do you understand the business and market? The process of building the model forces you to answer the difficult questions related to the business model and give a complete picture of the opportunity. Most importantly, how are you going to make money? What did you expect from a long time start-up CFO?

Related to this, I got an email from an entrepreneur this week interested in meeting with me. Unfortunately, I don't have time to take all of these requests, but always try and help where I can so offered to respond by email. Thought it would be appropriate to share his questions and my answers below related to the topic at hand:

The main questions have to do with presentation of documents to VC's.

1.) Does a complicated sales build model make sense for a pre-revenue SaaS company? Analyzing each step of who comes to the website organic, paid, conversions etc

[SB] Having a bottoms-up model is helpful. Of course, this is all hypothesis at this point, but you want to make sure that your assumptions are consistent with market realities for other SAAS companies. Byron Deeter has a good blog post on SAAS metrics.

2.) How should you include market comps? I don't like doing top down models, but I want to make sure the numbers are based on the other people in the markets.

[SB] It is good to have a top down that is consistent with your bottoms-up, so I’d recommend doing both.

3.) How much needs to be shown in the form of a cashflow statement, and balance sheet? Also, do you show accounts payable/receivable in these as they are not accurate or real?

[SB] I include all of the statements in my models to be complete, but nobody should care about this on a prospective basis. For actuals or short-term projections, much more important. When I look at a model, I care most about the assumptions around the business model. I want to get a good idea of the drivers and what is most important for success. I also want to know how you think about the business and how well you know the market, which becomes apparent through how the model is constructed.

4.) Would you put the assumptions/variables on one page that drives the numbers throughout the spreadsheet, or do you put them above each month so they can be altered monthly.

[SB] Ideally, it is good to have all of the assumptions in one tab, so it makes it much easier to do sensitivity analysis. I like to have one tab with assumptions and one tab with summary financials and key metrics. If the model is constructed properly, you don’t really need to look beyond these. I also typically, write a text document summarizing the assumptions, validation for the assumptions and key metrics. However, sometimes (particularly in the early periods when annual is too long a period), you may want to have some of the assumptions on a monthly basis within the appropriate tab. I often do this in the revenue tab.

Hope that was some helpful advice from ProfessorVC. Feel free to chime in with your thoughts.

I'm heading up to the mountains with the family this evening and should probably get ready for that other common Dad question coming from the back seat, "When are we going to be there?"

One final note: After labeling myself as "the last blogger in Silicon Valley", I am now doing the same thing on twitter. Wanted to make sure it was going to catch on...You can follow me @professorvc, and hopefully will comment more frequently than this blog.

Monday, June 20, 2011

How much is enough?

Financing, that is...I had mixed emotions when I read the the press release on the recent funding of iControl Networks.

I was the founding CFO for iControl and spent over 4 years with the company (the reason I call myself a part-time CFO and not interim as I tend to remain longer than most permanent CFO's...) Since the iControl system chronicles all meetings, I was able to find the automatic picture snapped from my first meeting with the founders, Reza Raji and Chris Stevens on April 22, 2004.

Now that iControl has raised over $100M, this got me thinking back to our original business plan. One truth of start-up financing is that it generally takes twice as long and twice as much money to accomplish your milestones. I took a look back at our original financial model we presented to VC's in 2004. The business model (OEM through broadband and home security companies for mass distribution) if not specific product functionality has remained largely the same. But of course, the model had us requiring only $10M equity to breakeven and to achieve $185M in revenues in 2008 (the magic Year 5 in all business plans).

I am no longer an insider, so don't have any view into current financials, but do know that total financing is now 10X the original plan and at the current accelerating growth rate, revenues will still not hit that $185M until 2012 or 2013, so double the time. And this is a company that has managed to get an A+ list of investors and is executing very well. Most companies don't come close to their rose colored financial models prepared when going out for Series A financing.

There are definitely some lessons in the story for entrepreneurs and angel investors, but before discussing, I thought I'd share a bit about the early financing history for iControl. Before the $52M Series D, the $23M Series C, the $15.5M Series B and the $5M Series A, there were angels writing checks with many less 0's. In looking back at the old financials, at the end of Q2 2005, our cash balance was a whopping $546. At this point, Reza and I were funding the company to keep the lights on and servers running. We had spent the $275K raised from our original angels and were actively speaking to any and all angels and VC's we could convince to meet with us. In fact, since the iControl system was busy taking pictures of all entering our conference room, we could put together a photo album of all these meetings.

At this time, we had secured a term sheet from a co-investor from one of my other angel investments (Thanks, Graeme!) offering to invest $75K if we could find another $250K by September 30, 2005. We managed to pull together an angel syndicate and close $450K on 9/30 after working the phones the last few days and anxiously waiting for signature pages to show up on the fax machine and wire confirms to hit the bank account. Less than a month later, we received a term sheet from Charles River Ventures for the Series A and as they say, the rest is financing history...with investments from Intel, Kleiner Perkins, Cisco, GE, Comcast, ADT, Rogers, and others.

So what does this all mean. As I said up front, I have mixed emotions about the financing. While my ownership stake in the company has been diluted through these financings (and the merger with uControl), my carried interest (paper value of my equity) has been going up with each increase in valuation. However, each financing resets the clock as new investors are looking for a multiple of their investment on exit.

Entrepreneurial finance (I should know since I teach the course) is all about options. Staged financing gives investors options in deciding whether and when to invest more and gives entrepreneurs options in how much to raise and when to think about exiting. While bootstrapping, there are multiple options from doing as a side project, changing the business, raising angel or venture, etc. Once you raise a small angel financing, you still keep many of your options, but are now committing to a growth path with an eye towards eventual liquidity. A talent acquisition or bootstrapping are still options, but need to include buy-in from the investors. Once you raise venture capital, you are forced on a path to spend ahead of the business and seek the highest growth business model options. In iControl’s case, there were exit options at different stages, but now with more than $100M invested, the only options where investors will be happy will be an IPO or $1B+ acquisition, which greatly limits strategic options.

Is $120M enough capital to reach these exit goals? I sure hope so, but we'll have to wait and see how the founding team and angels come out at the end of the day. Stay tuned...

Thursday, April 7, 2011

Why I Hate Convertible Debt...Let Me Count the Ways

My partner in Menlo Incubator, Gary Kremen, and I had a recent debate on which one of us hates convertible debt more. We weren't able to declare a winner, but I did agree to write a blog post on the topic. This will also serve as a good pointer for all the entrepreneurs who ask why I am not interested in their company led convertible note financing round.

I thought about doing this in a top 10 format, but will limit to my top 3 reasons:
  1. Misalignment of incentives - As an angel investor I want to do everything I can to help the entrepreneur succeed. In a convertible note structure, I'm penalized for increasing your valuation. Instead of getting a 2-3x multiple from seed to Series A, I get a discount off of the Series A, so I'm better off financially with a lower valuation. Investors are taking all of the downside risk and not getting the upside.
  2. Is This a Bridge or a Pier? What is the debt converting into? At some point, the debt has to convert or be paid back. Convertible debt can be like a drug - "just a little bit more and we'll hit that milestone". I've seen a number of entrepreneurs, angels and VC's fall into the trap of providing debt in small pieces. It all adds up and the more you have the bigger the round needs to be justify the valuation based on new cash in.
  3. Why Invest in an insolvent company? Technically, the start-up is insolvent from the day they take the first dollar of investment. This can make it much more difficult to get any bank financing, new investment, and trade credit. Most entrepreneurs don't realize this, but they have actually given a lot of control to investors with convertible debt. Depending on how the transaction is structured, investors could block a financing and potentially take over the intellectual property. Most don't have any interest in this, but why take that risk that one of your investors may decide to call the note.
The arguments for convertible debt are that it is quick, easy and cheaper to get a financing done. There isn't a need to negotiate a number of terms in standard preferred financing documents and legal fees will be less. From my experience, negotiating debt deals with an experienced investor will result in a number of the same terms and won't save much (if anything) on legal fees. Particularly, now that standard Series Seed docs are commonly used.

So when does convertible debt make sense? In cases where it is truly a bridge financing (i.e. venture term sheet negotiations in progress with strong likelihood of closing), I'm willing to take that risk and don't deserve a ton of reward for taking the additional risk at that point. Also, for first money in from friends & family, it makes sense. In some cases, where the round is very small ($100-$200K), it doesn't make sense to price. However, I would generally look to increase the size a bit and price if I were involved.

There was a good post recently by The Funded, "The Year of the Start-up Default" that discussed the potential ramifications of all of the convertible debt outstanding now. There are probably thousands of companies that have taken convertible debt in the past 18 months. Most of these are not going to raise venture financing, get acquired or become profitable. Even the ones that do get to cash flow breakeven, will not likely be in a position where they could pay back the debt. So what happens to these companies? Some will just shut down. Others will attempt fire sales. Many others may end up filing for bankruptcy or doing an assignment for the benefit of creditors (ABC).

You may say, if you are investing in the next facebook or google, why care about valuation? The returns are going to be so big that you want to have a piece of the best deals rather than more ownership in companies that aren't going to do well. That seems to be Paul Graham's (YCombinator) argument. However, using portfolio theory, your losers are going to far outnumber your winners, so taking half or more of the gains out of the winners will have a big impact on the overall returns.

So, the next entrepreneur that tries to convince me that a convertible debt is good for everyone, I'll say, "Let's figure out how much money you need to get to a significant milestone, raise the funding, price the round, and work together to build value. If we're successful, everyone wins. If we're not, let's go down on the ship together and hopefully stay out of those lawyer (I mean shark) infested waters..."

Friday, February 18, 2011

A Lot of Horn Tooting over a Kazoo sized deal

The LinkedIn acquisition of CardMunch a few weeks ago caught my attention. Techcrunch called it one of the "most like-minded and forward-thinking acquisitions I’ve ever seen"

I met with the founders of CardMunch several months ago when they were out raising their Series Seed round. They have a cute little app that takes a picture of a business card, populates your contact database and data is confirmed through crowd sourced labor. This is a cool way to solve the stack of business cards sitting on your desk and through geocoding lets you know where you met. You can also spread dozens of cards across a conference table and snap away.

I liked the founders (Bowei and Sid) a lot more than the business. CardMunch seemed like a nice feature and wasn't clear if there was even a product, let alone a business. It was going to be challenging to get scale with a model that charged on a per business card basis, a requirement given the amount of funding and cost for the crowdsourced labor. I generally only invest when I can think of at least half a dozen potential acquirers off the top of my head. In this case, LinkedIn was the only logical one that came to mind and didn’t see a viable business model short of that result.

Given that, I wasn't completing surprised when Linked-in announced the acquisition last month. I assumed they weren't able to raise funding and early exits often work out great for the founders, although not necessarily investors. However, after reading some of the press and tweets by investors, I began to wonder if this was a much bigger outcome than I would have guessed. A stock acquisition is a bet that would provide significant upside (and possible downside) opportunity.

I was curious about the sale price (not announced in any of the acquisition articles), but was disclosed in Linked-In's S1 filing at cash proceeds of $2,394,000. Seemed like a good time for ProfessorVC to do a little digging to see if there was more than met the eye.

I first contacted my friend, Manu Kumar, who incubated the company, coming up with the idea and finding the founders to build the product. He obviously has a founder's common stock stake along with cash invested. I asked him how the deal came out for investors since the sale price was significantly lower than the valuation on the round they were raising when we met. It looked like the preferred investors would get their money back and the founders would get a nice payday for a year's work. Nothing wrong with that and something that Basil Peters writes extensively about in Early Exits.

However, Manu's response made it sound like there was more there (or possibly a shovel involved):


There was *a* number reported in the LinkedIn S-1, but that doesn't tell the complete story. Other than complying with the filing requirements for the S-1, the terms of the CardMunch deal are private, and we are not allowed to discuss them.

At the time when you met with the CardMunch team, we'd already raised some amount of capital for the seed round. We stopped the fund-raising mid-way once we were approached by LinkedIn and engaged in discussions with them. The transaction was actually a great exit, and *everyone* (including the Series Seed investors who came in less than 2 months before the exist) made money on the transaction. It was a brilliant exit -- from start to finish in 13 months! :)



Ok, so maybe there was more to the deal than announced, but typically the S1 would include contingent payments (outside of the normal 20% escrow) such as earnouts or stock. I began to wonder based on the "*a*" number comment that perhaps Linked-in had thrown in a sweetener to the investors, such as an opportunity to buy some secondary shares pre-IPO or an allocation in the IPO. Given the issues we had in the past around allocation of IPO shares, this would be a very sensitive issue. Mind you, this is clearly speculation on my part (what are blog posts for?) and has no basis in fact.

Time to do some more digging. I ran across a couple of blog posts by another angel investor in Card Munch, Ty Danco. One was on the acquisition and the other on his original investment. I posted a comment on Ty's blog regarding the economics of the deal and was surprised to find that he had deleted some of my speculation and added the following comment:

Ty’s note: I’ve edited the rest out, as Professor VC asked specific valuation questions, posing some questions I can’t discuss. Sorry, but as is the case often in sales where the buyer has bigtime legal counsel, I’m precluded from giving out details.
Thus, I am raising my questions here. Perhaps, there is more to the deal or maybe it is just a face saving gesture on the part of investors.

Why can’t anyone just say, “it wasn’t a great outcome for investors, but was for the entrepreneurs and glad we could help make that happen”. I guess nobody wants to pull a kazoo out of their pocket when it feels so much better to blare a trumpet.