Please Don't Celebrate Failure!

Silicon Valley and the venture capital industry were built on taking risks and making big bets on technology, teams, and markets.  It's great that failure does not need to be worn as a scarlet letter as it does in other cultures or Hollywood...(wonder if a pic of Emma Stone will get a few new visitors to the ProfessorVC blog).

I remember back in the day when VC's took risks and would invest in nascent technologies and markets.  Now firms are more interested in piling on a late stage financing for an Uber or Slack after product/market has been de-risked and the only question is whether the sky high valuation will ultimately supported by the financial markets.

For a number of years (or at least since twitter has been around), the Silicon Valley echo chamber has publicly celebrated modest exits or acqui-hires.  However, now, it seems that the pendulum has swung so far the other way that failure is being celebrated.  Every week there is another post about "how we failed".   Medium seems to be the platform of choice to promote your failures.

Here are a few:

• Well We Failed, 
• Postmortem of a Venture-Backed Startup and 
• My Startup Failed

I recently had a fireside chat with Dave McClure at SJSU where I questioned Dave about a blog post he wrote on failure, late bloomer, not a loser (I hope). You can skip ahead to the 37:35 mark where Dave lets out the secret that writing about being a loser will get you a huge audience for your blog.



SVCE Speaker Series: Dave McClure from SJSU CoB on Vimeo.

Perhaps, those entrepreneurs are just looking to make a few bucks with google AdSense and Commission Junction while figuring out next career move...

I agree it is good to share lessons learned with other entrepreneurs.  Also, if it is cathartic for you to do a post-mortem for the world to see, I'm not going to stand in your way.  However, where I draw the line is when failures are treated as less than a little speed bump on the road to success.  FAILING SUCKS!! YOU ARE IN THE GAME TO WIN!! EMPLOYEES LOST THEIR JOBS AND INVESTORS LOST MONEY!!

Ok, now it's time to reveal what got ProfessorVC's tighty whities in a bunch.  I received this email from a CEO/founder of a company where I was an investor on April 14th at 8:29 PM:

Thank you for your belief in me and the entire team. We had bold visions for how we were going to upend research and investment in the private market, and we wanted to make that vision a reality. Unfortunately, like many startups, we’ve run out of runway to execute. As of April 15, company will be effectively out of cash.

Yeah, you read that right!  Oops. we're running out of cash tomorrow!! Oh well, we failed...This was with no advanced warning and only bullish statements on company's progress.  It's one thing to be an optimistic entrepreneur but another to be delusional and reckless!  Apparently the entrepreneur (can't tell you who it is but his name rhymes with Saul Pingh) was too embarrassed or arrogant to respond to my requests for answers and more info.  Another investor had to threaten to have his lawyer make the next request before getting a call.  It turns out there was ultimately an acquihire and investors may potentially receive a very small fraction of our investment back.

As an investor, I expect to lose money on many of my investments.  That's part of being an angel investor and luckily the returns on the winners far exceeds the losses on the losers.  However, if entrepreneurs are going to build their companies on other people's money, they need to communicate and work like hell to win!  Sorry, contrary to popular belief among the millennials, there is no trophy for losing (actually, a quick google search shows there is one).

Please don't win one of these!

PostScript: The identity of Saul Pingh was discovered by a DC reporter Chris Bing following in the footsteps of those other DC investigative reporters Woodward and Bernstein...Chris attended the celebration of the acquisition (pic below)

On April 16, the acquisition deal for Disruption Corp. by 1776 was announced. Those pictured include 1776 co-founder Evan Burfield (far left); Virginia Gov. Terry McAuliffe (center, behind podium); 1776 co-founder Donna Harris (to right of McAuliffe); and Disruption Corp. founder Paul Singh (far right). DC Inno photo.

Pari Passu or F.U...little guy

Mike Markkula presenting Steve Jobs with first investment in Apple

I recently watched an excellent documentary on PBS, Something Ventured: Risk, Reward, and the Original Venture Capitalists.  It is the story of the founding of the venture capital industry in Silicon Valley and features many of the iconic companies created including Apple, Intel, Genentech and Cisco.  VCs profiled include Arthur Rock, Tom Perkins, Don Valentine, Dick Kramlich, Reid Dennis, Bill Draper and Pitch Johnson (fathers of the industry).  Yup, no women, unfortunately, and industry is still male dominated over 40 years later.

The documentary is well worth watching.  It is both entertaining and a stark contrast to today's venture climate, that is dominated by sharp elbows and the focus on personal gain and self promotion (or the more acceptable term of creating a "personal brand").

Perhaps, I'm becoming an old curmudgeon, but I like the focus on working together to create something really big. This is the feeling you get from watching the venture capitalists talk about the entrepreneurs and other investors in the film.

Pari Passu is a term that was used quite frequently in the early days of the venture industry and even when I got my feet wet in the late '80s and early '90s.  It is a Latin phrase that means "on equal footing" and has been translated to mean "ranking equally", "hand in hand", and "fairly" according to Wikipedia.  In investment parlance, it strictly means that new classes of stock have equal rights with prior classes in terms of liquidation preference, voting rights, etc.

However, I view pari passu as a more intrinsic definition that goes beyond simple legal definitions. I'm a strong believer in fairness (although my daughters may not agree) and investors and entrepreneurs working together as a team to create something valuable to all stakeholders (customers, employees, founders, investors).  Startup outcomes tend to be very binary. The company either fails and provides little or no return to investors or is a success and returns a multiple to investors.  Yes, there are a number of cases in the middle where having a senior or participating preference does make a difference in liquidation proceeds, but I argue that it does very little to overall returns in a diversified portfolio.

I've witnessed a lot of bad behavior by investors recently, along with other examples of greed that stray far from pari passu.  I'm all for transparency, but won't be naming names in this post as I don't want to put some entrepreneurs in a difficult position.  However, I'm sure some of ProfessorVC's readers will recognize themselves or others in these examples.  It's also interesting how a lot of this resembles toddler behavior on the playground from "show me a little more love" to "mine mine mine" and of course, the classic playground bully.

One area I've noticed a lot more recently are angel investors and seed stage funds trying to grab a little bit extra, whether it's warrants for leading the round, advisor shares to go along with the investment, or a common stock stake for just being who they are.  Entrepreneurs are put in a difficult position as they are trying to get a round closed, benefit from having certain investors committed, but at the same time can't feel very comfortable having to tell prospective investors they aren't getting the same deal.  I always ask the question if other investors have different terms and almost always don't invest on principal in these cases.

Another closely related area is that of variable pricing on convertible debt or equity deals where different investors have different caps.  Generally (but not always) it is investors that came on board a little earlier.  As regular readers of this blog know, I'm not a fan of convertible deals to begin with, and it is difficult for me to internalize how value in the company has been created in the two weeks a cap goes from $3 million to $5 million.  I have turned down several of these types of transactions recently.

Seems like my rant is picking up steam now.  I was working closely with an entrepreneur and introduced another angel investor to the company.  We considered a joint investment in the company and the entrepreneur decided not to take funding at the time.  A year or so later, the entrepreneur did raise a round from a seed stage fund that wanted to have most of the round, but the guy I introduced was able to invest, while I got left on the outside.  Company has now raised over $70 million and is growing rapidly.  Yes, the entrepreneur could've worked to get me in the round, but not the easiest position when you are a young CEO raising your first round.  The other investor could've certainly lobbied to get me an allocation.

Another area where I'm not sure I stand is with some of the more formal referral and syndication programs that are emerging now.  Funders Club (which I've written about previously)  recently launched a referral program where angels can receive 10% of the carried interest in a deal they refer that ultimately gets investment from an FC fund.  Since this only impacts the investors participating in the deal through FC, I don't have a big problem with this, although not something I would participate in.  Not sure how much value in just a referral, but also going back to pari passu, I'm just as likely to refer the next opportunity and am happy investing at the same terms on one I refer as one that you refer.

AngelList (which I remain a big fan) also recently launched a syndicate program.  In this program, an angel can ask the entrepreneur for an allocation of the round and then syndicate through AngelList.  It is assumed that the angel has done diligence and will be working with the company going forward to earn a carried interest from others investing in the syndicate.  Effectively, the angel is acting as a VC and works in a similar manner to a pledge fund, where a firm's LPs commit on a deal by deal basis.  I could see potentially getting involved in this type of transaction, but am curious if the investor is committing to the full allocation whether she can syndicate or not.  If it is contingent, then this could provide some perverse incentives.

Finally, I have to bring up some bad behavior by a name Sand Hill Road firm (SH).  An entrepreneur received two Series A term sheets, one lead by an international investor and the other from SH.  The seed round had participation from two venture firms that were committed to doing their pro-rata and seed round was done with a very clean term sheet (1x preference, non participating, no anti-dilution).  SH wanted a senior preference over the seed investors (full disclosure: I'm one) and we tried to push back that precedent was being set for Series B and whoever comes after them, to demand the same, which will negate the value of their seniority at A.  Unfortunately, not everyone follows the KISS principle.  Their response was that we should be happy they didn't ask for a participating preference on top of the seniority.  Lucky us!!

We went ahead and accepted the term sheet, partially due to the fact that they knew the company well from 3 months of diligence, had expertise in the domain, and promised a quick close in 3 weeks from term sheet signing.  Well, those 3 weeks came and went, and they decided they weren't sure about the market and needed to get other partners in the firm on board.  That is VC speak, for get ready to bend over...After several meetings with different partners, principals, venture partners and associates, they scheduled a partner meeting for one month after the original close date to decide if they wanted to move ahead.  They did get the partners on board on the condition that the term sheet is renegotiated at a lower valuation.  Don't know why I'm thinking of Kevin Bacon from Animal House all of a sudden. "Thank you sir, may I have another!"

Just in case you are forgetting at this point, I'm not a pollyanna. It's also not a Rodney King "Can't we all just get along" thing.  I'm a capitalist, a CFO and investor.  I know it's all about capital and using wealth to create more wealth.  However, Wall Street was never an appealing destination for me (unlike the majority of my Wharton classmates) and as much as I snickered, I liked it when VCs started referring to their investments as projects rather than deals. The venture industry has clearly changed and grown since the early days profiled in Something Ventured, but it would be good not to forget all of the lessons shared in the documentary.

Series A Crunch...just Darwin at work

As December and 2012 draws to a close, I've decided to weigh in with my thoughts on the impending (or not depending on which blogs you read) Series A Crunch.  It seems that The Series A Crunch has been discussed almost as much as the Mayan calendar this month and I've mostly sat on the sidelines figuring that if the world were really going to end, I had better things to do than write a blog post.  Alas, we survived 12/21 and looks like we will have to get back to work in 2013.

For those readers not already familiar with this concept, it refers to the bottleneck for Series A financing created by the increasing number of seed financings and constant number of Series A financings.  While this has been discussed ad nauseum on twitter and the blogosphere, I have relevant perspective given my three different roles in the new venture ecosystem - investing in seed deals as an angel, raising seed investment as a start-up CFO and teaching entrepreneurial finance as a Professor. 

I'll summarize some of the varied opinions and data before weighing in with my own thoughts. A good place to start for data is CBInsights' Seed Investing Report- Startup Orphans and the Series A Crunch.  According to their research, 2,283 companies received seed funding over a 5-quarter period beginning Q3 2011.  Out of these companies, 102 have received follow-on funding and 212 have been acquired (or more likely acqui-hired).  Out of the remaining 2,200, they estimate that 1,200 will not be able to raise follow-on financing (see visual explanation below) and $1 billion in angel investment will likely evaporate.

Is this a high success rate?  Is this a low success rate?  Is this Armageddon?  Depends on who you read.  Sarah Lacy started this round of debate a few weeks ago with The Series A Crunch is hitting now.  Jason Calacanis responded and argues in There is No Series A Crunch that this is a non-issue and up to the seed financed start-ups to prove they are worthy.  If there are more companies that have met Series A milestones and metrics, VCs will increase the number of Series A financings.  If you are entrepreneur that isn't in a position for Series A, find other financing sources and/or figure out how to bootstrap to cash flow breakeven or in Jason's words "put on your big boy undies". Sarah, of course, responded with Jason is Wrong. Have we reached the "Jane, you ignorant slut" point?

For those who haven't already left this post to catch the latest YouTube cat video, let me see if I can bring these divergent opinions together.  I did finally chime in on the twitter discussion yesterday:

I first blogged about this topic almost two years ago when I called out the large number of convertible debt seed financings that weren't going to have any conversion event.  It turns out the financing instrument probably isn't as material as I had thought, although it doesn make the mechanics different.  From an investor standpoint, I've discovered there actually can be greater leverage with convertible debt if the appropriate protections have been included.  I've had a couple of deals where investors were paid out a multiple on exit and in a better position than if holding preferred stock, where the payout would have been subject to escrow and over multiple years.

Is it a good thing that so many entrepreneurs are able to get $250K - $1.5M in seed financing? HELL YES!!! Investors know (or damn well should) the risk they are taking in making seed investments.  The accelerators clearly know the game and the ground rules.  If as CBInsights posits, $1B is going to be lost by angels in seed financings, one Instagram makes most of that back and presumably there will be positive returns on a material percentage of the remaining companies.

Giving more entrepreneurs the ability to step up to the plate is a good thing.  I love the accelerators and am a regular on Demo Days for 500 Startups, YC, AngelPad and others.  However, many of the graduates of the accelerators aren't even companies, let alone businesses.  They are projects and experiments.  These are part of the entrepreneurs' education.  Learn how to build a product, pitch investors, raise a small amount of angel funding, hire the early team, acquire users, sell, iterate.  If it works, great.  If not, move on and join another team or come up with another idea with the same or different co-founders.  With my academic hat on, this is wonderful.  I specialize in experiential education and there is no better way to learn entrepreneurship than doing it.

My recommendation used to be that it was best to do this learning on someone else's dime and would advise students to spend a few years working in a start-up or potentially large tech company before doing own start-up.  However, they now can still do this on someone else's dime, but it is the angel investor and not an employer.  As an angel, do I take this kind of gamble?  Sometimes, if I feel the opportunity is big and the team is fully committed.  But generally, I'm also looking for those proof points that go beyond what most entrepreneurs coming out of an accelerator have.  Domain expertise is critical and many of these entrepreneurs don't have enough.

So, what are the key takeaways for entrepreneurs besides pulling up their big boy (or girl) undies:

1. Keep your options open.  Don't raise seed financing with only one path to raise Series A.  I'm not a fan of "Go Big or Go Home".  That works great for big venture funds with a broad portfolio, but not so good for an entrepreneur committed to a market opportunity.  Have a plan for Series A, but also have a plan for slower growth, intermediate funding, and a route to cash flow breakeven.
2. Seek appropriate financing.  Most businesses don't fit the venture model and if that is your only path, the most likely outcome is hitting the wall.  I always hate when folks disparage an entrepreneur who is building a "lifestyle business".  If you can build a business that provides a good income, doing something you love, living where you want, and pursuing passions outside of the business, more power to you.  I'm guessing that's how Richard Branson started and he seems to have a nice lifestyle.
3. Nothing wrong with a cash flow business.  Follow around a middle market private equity investor for a few months and you will likely discover some businesses that have great cash flow potential. Unless yoru only end game is being acquired (and if so read point 1 above again), the experiments need to yield a business model that can create a sustainable business that isn't dependent on continued funding to remain off life support.

That advice should work in good times, bad times and all those in between.  

Angel Groups Panning for Gold

ProfessorVC just returned from an Alaskan vacation and was mortified to realize it was almost six months since the last blog post. One of our stops was in Skagway, which became the biggest city in Alaska during the Klondike Gold Rush.  Most of the prospectors came up empty and of those who did strike gold, most lost their new found wealth through bad investments or dealings with swindlers. This got me thinking about the "suckers bet" of angel investing and how most don't strike gold for a variety of reasons.  Interesting enough, it was an entrepreneur (John Nordstrom) who was able to get out of town with his gold and opened a little shoe store in Seattle.
 
Earlier this year, I left Sand Hill Angels, the angel group I was actively involved with since 2005.  I've been meaning to share my thoughts about angel groups and will do so in an upcoming post.  In the meantime, I ran across the recent Halo Report on angel group investing prepared by Silicon Valley Bank.

 Some of the nuggets from the report are summarized in the infographic below.

A few of my takeaways:

• Interesting that 81% of deals completed outside of California.  This compares with less than 50% of venture deals being outside of California.  I would guess that overall angel investments are greater than 50% in California, which means that angel groups are active in areas where VCs and individual angels are not.  With deal velocity so great in Silicon Valley along with the large numbers of experienced entrepreneurs and investors, there is little need to associate with an angel group.

• Median pre-money valuation of $2.5 million also indicates a majority of deals being done outside of California, where I would guess the median is closer to $3.5M.  There are a number of reasons for the premium, not the least is the cost of engineering talent.

• Internet dominates total deals while Healthcare received the largest share of funding.  If you add mobile, ratio is greater than 2:1 on deal basis and a little higher on funding.  With the low cost of creating these companies, they are a good fit for angel groups that can move quickly, make a number of bets and have the ability to follow-on.  Healthcare (primarily medical device companies) are very well suited for angel investments.  At Sand Hill Angels, we invested in a number of these medical device companies that had serial entrepreneurs, patents filed, low valuations, and clear paths to exit.  The investment thesis made sense from both sides as funding could get to (or though FDA) and requirement for further funding was low.

Negotiating an Angel Deal in your PJ's

Well, not exactly...I was part of a Dow Jones VentureWire webinar last week titled Negotiating An Angel Deal: What Angels, Entrepreneurs & VCs Need to Know. I prefer the traditional face to face where you can interact with the other panelists and audience, but was the first panel I did wearing my favorite flannel penguin pajamas...

It had a good mix of viewpoints with east (James Geshwiler, Common Angels) and west coast (yours truly) angels, early stage venture capitalist (Jason Mendelson, Foundry Group), and a couple of attorneys (Dan Hansen and Mario Rosati). It is obviously too late to dial-in to the call, but you can still order a CD of the session. If you don't want to spring for that or spend 90 minutes listening for that one nugget you are looking for, I'll share a few of the topics I found interesting.

• Dumb Money - Are we as dumb as we look? One comment made by Jason was that angels tend to be less sensitive than VC's on valuation and can potentially make it difficult to get a venture financing done at acceptable valuation. While this may certainly be the case with unsophisticated angels (much less of these now) or in cases with no lead investor, I'd argue the opposite. We are typically looking at either smaller exits or require a lower valuation to get a reasonable step-up to a venture round. In my experience, venture investors are more focused on percentage ownership, which obviously requires a trade-off with the amount invested and valuation.
  

• KISS - No, not one of the guys on the left. The old Keep It Simple Stupid Principle. I had a discussion with another angel investor a few months ago and he was bragging about the deal he just struck that included a 3X participating liquidation preference. I let him know that he just accomplished two things - left a bad taste with the entrepreneur and opened the door for the next investor to ask for a multiple preference that is senior to yours. While upstream investors can certainly ask for more in any financing (The Golden Rule), it will be much easier to get simple terms if the precedent has been set from the beginning.

• A related topic is the standardization of terms. There has been a lot of discussion and publishing of standard term sheets, including Y Combinator, TechStars and SeriesSeed. A good comparison of the various "standard" term sheets can be found at Start-up Company Lawyer. Mario's firm, Wilson, Sonsini, even has a term sheet generator on their site. You answer a few questions and similar to TurboTax, out pops a term sheet instead of your tax return. Not quite as much fun to play with as the Dilbert Mission Statement Generator, but probably more useful. Consensus seemed to be that all of these "standard" terms are a bit different and while not possible to completely standardize (no company or financing is exactly the same), the guiding principle should be to keep it simple (see above) and minimize legal fees.

One other topic discussed was the recent legislation introduced by Sen. Dodd that could have a big impact on angel investing and job creation. A couple of items buried in the 1300 page bill include changing the definition of an accredited investor and moving regulatory roles on private3 placements from federal to stage level. This will both reduce the number of angel investors and make it more difficult to syndicate across stage lines. Lobbying is ongoing by both the National Venture Capital Association and Angel Capital Association and James Geshwiler on the panel wrote a recent post on the ramification.

I will be speaking on a related topic next week at an SVASE event in Palo Alto, "Founders vs. Investors - Are we all on the same page" Hope to see some of you there and promise I won't show up in my pajamas.

Watch Out for the Red W(h)ine

I have been following the rallying cry of entrepreneurs with some amusement over the past couple of weeks in response to a blog post by Jason Calacanis, "Why Start-ups Shouldn't have to pay to pitch angel investors." In fact, I was cornered by a member of this camp at our recent Sand Hill Angels annual social event at the Wine Room in Palo Alto (great place, by the way). I was afraid if I didn't answer the question of whether Sand Hill charges entrepreneurs to pitch properly, I might be wearing a very nice pinot.

I've written about the practice of charging entrepreneurs in earlier blog posts and it is not something we would ever do at SHA. However, the individual above was adamant that we should have a PR campaign to let the entrepreneurial community know that we don't participate or support this practice. I laughed and said that our web site made this clear and we may have even put a brief posting to this effect on our twitter feed. I'm also a strong believer that your track record and reputation are your most valuable assets in the venture community. This is not something that can happen overnight by putting a press release on the wire.

However, this is a great question to ask at the front of the process. I have put together a list of questions to ask your angel investor group contact:

• Do you charge any fees to present or during the due diligence process?
• How many investments have you made this year? Last year? Average size?
• How many of those investments are initial investments? Follow-on?
• In how many of those were you a lead investor?
  
• How many do you have a board seat?
  
• What percentage of your members have made an investment in the past 12 months?
• What percentage of your members are not active angel investors (i.e. service providers)?
• Do you invest as a fund, single purpose entity or as individuals?
  

This is not a comprehensive list of questions, but certainly a good start? At Sand Hill, we are very active and often lead investor and Series A board representative. We made 12 investments last year (5 new and 7 follow-on) and are on the same pace in 2009.

For those who do charge, should you avoid them like the plague or burn at the stake? I wouldn't go that far, but certainly fair to determine what you are getting for your limited amount of cash. Here is a list of questions I'd ask:

• How much is the fee?
• When are we obligated to pay?
• What do we get?
• Are you a broker-dealer? (Note: Finders fees are illegal in California for non broker-dealers, not sure about other states)
• Do you have any service provider members? Do you charge them a fee?
• If you do charge, why are you you charging me for the privilege of being added to a telemarketing list? Shouldn't you be paying me?
• How many companies have paid fees in the last year?
• How many of these have received investment for your group?
  

I don't think it's time to hang all angel investors in effigy, but remember that due diligence goes two ways...

What does it take to be an Angel Investor?

This is often a tough question to answer. To the SEC, it means that you are an accredited investor and To the man (or woman) on the street, a minimum qualification would seem to be an interest and ability to invest in early stage ventures. However, that is not always the case as there is no qualification to set out your shingle as an angel investor or form an angel group. I often wonder if saying you are an angel investor is the 21st century version of being a consultant in the early 1990's after the corporate layoffs, a euphemism for someone without a real job.

I attended the ACA Summit in San Diego earlier this month. I ran into a friend who was wearing a nametag from another angel group and I inquired as to why she had never shown an interest in joining Sand Hill Angels. Her response was that we required our members to make investments and the other group didn't....Silly us, with that kind of a requirement. I think this sentiment has given angel groups a bad name. An entrepreneur will pitch their business plan to what they think is a group of angel investors and will get a number of follow-up calls afterwards, but they are pitches for services not investment interest.

The ACA is an interesting organization and is providing support in a number of ways to its member angel groups, from public policy, networking, sydnication, and best practices. The National Venture Capital Association (NVCA) was also represented at the conference and is forging closer links with the ACA. In fact, there are some members of both groups, as a number of angel groups have raised funds (that is an entire discussion that I'll leave for a future post).