Does Elon Musk + Peter Thiel = 3 or 1.5

I've written previously (here and here) about the issues with private companies merging in an acquihire or other downside scenario (i.e. one company running out of cash and another with cash but searching for a business model).  Often times those involve trading within a venture capital portfolio or between two venture firms portfolios.

But what about the case where both companies are well capitalized and doing well?  I think we will see more of these in 2016 and beyond as IPOs are still far and few between and unicorns struggle to justify their stratospheric valuations.

One of the first I was exposed to was the merger between Peter Thiel's Confinity/PayPal and Elon Musk's X.com.  Both companies were relatively well capitalized, building peer to peer payments businesses and spending a significant amount of their funding on customer acquisition.  According to David Sacks (PayPal's COO at the time), both companies were involved in a scorched Earth battle to acquire customers (upping referral bonuses to $20) that neither were likely to survive if they continued down that road and the merger solved this problem (although created others).

Obviously, Musk and Thiel both did fine off the eventual Paypal IPO (and even better subsequently with Facebook and Tesla).  Musk was the early winner taking the CEO role (for a brief period) in the merged company and the largest equity stake as well.  Not surprisingly, the merger was highly dilutive, particularly to Confinity/PayPal shareholders.  I was a Limited Partner in Angel Investors II (Ron Conway's angel fund) that was an investor in Confinity.  At the IPO, Musk held a 14.2% stake vs Thiel's 5.6% (Sequoia Capital had 10.7%).

For the LP's in Angel Investors II, the investment ended up returning around 7x (but only 1% of the fund), which was a very good return but not as high as it could've been, and clearly not enough to make a dent in many of the other 150+ companies (most that went out of business) in a portfolio that included candybarrel.com, eRugGallery, and dunk.net.  Luckily, Google was one of the 150 and did ultimately return the fund assuming the LP was smart enough to hold the stock after distribution.

I originally got to thinking about this when I received a 485 page information statement on a previously announced merger between Clean Power Finance and Kilowatt Financial.  I was a seed investor in Clean Power Finance (CPF), which subsequently raised $90M+ in venture funding and  over $1 billion in project and debt financing.  CPF's major venture backer is Kleiner Perkins, who coincidentally, is also the majority equity holder in Kilowatt.  Like CPF, Kilowatt also provides solar financing services to consumers.  It is obviously too early to know whether this will be a successful merger, but I generally prefer to roll the dice with the original horse I bet on.  You also have to wonder about the numerous conflicts of interests involved in a deal where one investor owns a significant stake in both parties.

Another seed investment where something similar happened was the 2010 iControl Networks merger with uControl (yeah not a lot of creativity in naming...).  Kleiner was also the lead venture investor in iControl, which had raised close to $50M in financing at the time (I previously wrote a post about iControl's financing history).  Both companies offered home security and automation services through partners.  iControl had make significant inroads in the security industry (partnering with ADT to deliver ADT Pulse) while uControl had more success with cable and broadband providers.  As an investor, I wasn't very excited at the time due to the dilution and challenges in integrating the two platforms.  Looking back five years later, it appears that the merger was a very expensive partner acquisition strategy for iControl.  By the way, this month is the 10-year anniversary of iControl's Series A financing and I haven't been able to get liquid on a single share.  Hope that changes in 2016...

What does this mean for entrepreneurs and investors?  Here are a few thoughts:

• Expect more consolidation - While acquisitions of early stage companies often provide benefits to fill in product line, acquire a team, or enter a new market, later stage acquisitions are often a sign that one or both companies got stuck in the red zone and the hope that the combined effort can get the ball across the goal line.  

• Many acquisition are a Zero Sum Game (or worse) - This holds true for many public company acquisitions as well.  Press Releases always tout the synergistic benefits of the combination, but in reality, rarely are both entities better off.  Typically one comes out better and often both end up in a worse position.

• Resetting of Liquidity Clock - Similar to raising a large late stage private round, this also increases the combined enterprise value and limits potential exits to either an IPO or very large acquisition.  It takes time for the business to catch up to these market expectations and valuation.  Most never make it there.  I do wonder if we will being to see the rarely used redemption clauses triggered where early investors may be happy to take their money back plus accrued preferential return to close out a fund.

Back to that PayPal merger.  What would've actually happened if Confinity and X.com had continued to battle it out.  One thing I know is that the combined business turned out a lot better than Peter Thiel's original business plan for infrared beaming of electronic payments over Palm Pilots that I unfortunately passed on investing in 1999.  For those interested in an entertaining look back at Silicon Valley history, you can find that business plan here.

It might not be a bubble but sure as hell the rent is too damn high!

The above was the opening salvo of a controversial tweetstorm yesterday by my former student and 500 Startups founding partner, Dave McClure (full venom below).

I've known Dave for 20 years and one of my favorite parts about him is that he will always tell you what he thinks and make sure you don't miss anything through creative use of profanity and CAPS.  This tweetstorm really hits home (particularly #4 about founders getting paydays while angel investors lose money), although Dave says it better:

What is also fucked is with small exits $1-$10M, founders may get $1M paydays but angel investors at $5-$10M caps will lose money  

I invested in my first AngelList syndicate about 9 months ago in the authentication startup, Authy.  I started using Authy for two-factor authentication to provide greater security in my digital currency trading.  It was a great product addressing a large market opportunity and was interested in seeing how the AngelList syndicate process worked.  Suffice it to say when I saw the announcement that Authy was being acquired by Twilio less than a year after making the investment, I was initially excited.  As with all M&A exits, there was a round of congratulatory messages to the founder in the Silicon Valley echo chamber.

However, when I read the announcement and saw that the acquisition price wasn't disclosed, alarm bells started going off in my head.  This is often a sign of an acquihire or very small exit.  Also, a private company buying another private company is not a scenario I typically like, although Twilio certainly has excellent prospects and may go public this year, providing liquidity in the medium term. I already own stock in Twilio indirectly through a limited partnership interest in a venture fund and don't need to bet more on Twilio.  I don't know the reasons for selling, but presumably Authy felt their prospects weren't promising as a standalone entity and may have had difficulty raising further financing.  Due to confidentiality provisions, I can't disclose details, but there are many very unhappy participants who invested through the syndicate.

As a refresher, syndicates were introduced by Angellist a couple of years ago as a way for companies to raise funds in small increments from a large number of investors (SEC limit of 99 accredited investors).  Subsequently, they also introduced a platform for individual angel investors and funds to syndicate a piece of their investment in exchange for a carry on the syndicated portion.  Syndicates can either be company led or investor led.  In the case of Authy, it was company led, so the only fees and carry were to AngelList.  Conceptually, the syndication process provides a way for companies to effectively conduct crowdfunding and angels to act as VCs.

While I find the theory of syndicates appealing, particularly for individuals that wouldn't have access to deal flow on their own, I'm generally not interested in paying additional fees and carry when I can invest directly on my own.  If I'm going to pay a fee and carry, would prefer to invest in a venture capital fund, as the investments are being managed by professionals and have a duty to look out for LP interests.

However, I did want to check out the process to see if I might want to create my own syndicate.  It was indeed very easy to review the investment opportunity and fund through a complete online process.  Rather than owning a direct stake in Authy, I became a member of a single purpose LLC created by AngelList to invest in the offering.  The entity invested in the same capped convertible note as other investors.  AngelList's policy is to have the entity vote along with the majority of investors in the company (not the syndicate) when a shareholder (or in this case, debt holder) vote is required.

Once the specifics of the transaction were posted to the members of the AngelList syndicate, there was a heated discussion regarding how the transaction was valued in relation to the valuation cap.  The board decided not to use an external valuation of Twilio's common stock that had been done the month prior to the acquisition, but instead come up with their own valuation methodology.  Of course, this was favorable to holders of common stock (the founder being the largest shareholder) and in addition, the founder received additional benefits in the transaction, presumably at the expense of the debt holders.

Interesting thing about all of this is that one of the primary reasons Naval Ravikant started AngelList was to improve transparency in the investment process (along with access to deal flow).  Transparency became a huge issue for Naval after he felt he was screwed by VC investors prior to his startup (DealTime) being acquired by Epinions. In fact, he took the extra step and filed litigation against two Sand Hill Road firms, something that is rarely done  When syndicates were announced in 2013, I had a twitter exchange with Naval regarding the transparency issue in regards to the syndicate lead's investment.

Given the above, it is interesting that AngelList has been trying to avoid full transparency on the transaction.  I have heard from many investors who think they got a raw deal.  A number of the posts relate to how the Authy board determined the fair market value of the deal consideration, particularly in light of the board being controlled by the founder.  One of the investors in the syndicate says some of his critical posts have been deleted and he has been bullied by someone on the AngelList team.  While it may not be practical from a process or legal standpoint to have the individuals in the syndicate vote on corporate matters, they should be treated with complete transparency on the transactions rather than trying to decipher the hocus pocus on a  deal.

My intention of the post isn't to bash AngelList.  I have been a big fan of AngelList from day one and am definitely entrepreneur friendly.  In fact, I have been on the platform since it's early days as a daily email sharing interesting angel opportunities.  It has definitely grown up and become a major force in the entrepreneurial ecosystem.  However, I will think long and hard before joining another syndicate.

At the end of the twitterstorm is a response from YCombinator's Sam Altman:

.@davemcclure just worry about trying to make 10,000x sometimes, and let founders who work really hard for years w/small exit keep the money

I understand where Sam Altman is coming from in his response and it's fine for him to look at the big picture and accept that for his own investments, but isn't right to expect other investors to be so magnanimous.  Also, in this particular case it is a big ingenuous.  Authy was a YC company, so Sam's firm held a 7% common stock equity stake and benefited from the other angels holding the short end of the stick.  But as Dave says,

the truth of this matter is angels & small investors get FUCKED all the time by high cap debt, & founders don't seem 2 give a shit

If you are interested in drilling deeper in to this tweetstorm or discussing any other entrepreneurial topics, I am hosting a fireside chat with Dave on April 1 (No Joke!) at the new SJSU Theatre on campus as part of our Silicon Valley Center for Entrepreneurship Eminent Speaker Series.  We are also looking to break the current campus record for most f-bombs in an hour.  The event is free and open to the public.  You can register here

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):

"Steve,

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! :)

Regards,

-Manu"

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.

Baby's All Grown Up

It's been a while since my last post and it appears I missed the entire month of March. Not to worry, I was busy working on closing the Series B financing for iControl Networks. We ended up raising $15.5M, led by John Doerr of Kleiner Perkins.

This got me thinking about my role in helping companies grow up. I started working with the founders of iControl at the concept stage, prior to the first $100K of angel financing. For a while, it seemed like we were constantly walking along the edge of a cliff and had several near death experiences. In fact, for a good laugh, I just went back and checked our accounting system, and at the end of one quarter in 2005, we were down to $143 cash on the balance sheet. The CEO and I ended up funding the company ourselves until we were able to scrape together a larger angel round.

Now, the company is poised to change the home security industry, one that is in dire need of change. However, my role changes and I am moving from CFO and member of the executive team to cheerleader and advisor. It is not unlike watching your children grow up. With two teenage daughters, I am becoming quite familiar with the changes as your babies become toddlers, pre-schoolers, enter kindergarten, middle and high school. My oldest won't be off to college for a few years, but will probably happen in a blink of an eye.

At times, I do miss being part of a team that takes a company from infancy all the way to IPO and beyond. I have been tempted at various times to join one of my companies as full time CFO, but have decided that is not in the best interest of either party (me or the company). As the company grows, it is more important to have a CFO that is both strategic and skilled in process, rather than a "seat of the pants" entrepreneurial CFO. I personally enjoy the earliest stages and building a portfolio of start-ups and entrepreneurial teams.

The cheerleader role isn't all bad. Anonymizer, a company where I was an early investor, advisor and board member, just got acquired by Abraxas Corporation for a very nice multiple. Rather than home security, these guys are helping with our nation's security. Anonymizer raised a small amount of equity and was able to build a business that became very profitable. It took almost a decade from the initial investment, but in the end, worked out well for all involved. Come to think of it, this will help pay for those college tuition bills that will be coming....