So You Wanna be a VC?

Opening Day Barron Park Elementary School (9/8/98)

"Make new friends,

but keep the old.

One is silver,

the other is gold.

A circle is round,

it has no end.

That's how long,

I will be your friend."

(girl scout song believed to be adapted from poem written by Joseph Parry (1841-1903) or perhaps Boardwalk Empire if you believe Reddit)

In the picture above, "Make New Friends" was sung by the entire Barron Park Elementary School on its first day as a neighborhood school in 1998.  A fitting song for a new school year and new school. (Side note 1: My daughter with back to camera and her friend to her right in pigtails both graduated from UC Santa Barbara together in 2015.  Side note 2: School started on September 8th.  Yes, after Labor Day!  When summer is supposed to end, not in mid-August like Palo Alto and most other school districts do now.)

I've always believed in the golden rule.  You know, the one you learned in nursery school about treating others how you would like to be treated.  However, in my 25 years in the Silicon Valley startup ecosystem, I've experienced the VC corollary to the golden rule much more often: "He has the gold makes the rules!"  I can just picture Mr. Rogers saying "Children, can you say participating preferred stock with an uncapped 3x liquidation preference and a full ratchet?" Well, maybe so after watching his middle finger salute.

When AngelList first launched syndicates a few years ago, I was very skeptical of the idea of angels taking carry on my investment.  I've always felt that as an angel we should be sharing our best opportunities with each other and follow the golden rule.  I work hard on mine and you work hard on yours and we all win (entrepreneurs, angels, and upstream VC's).  I went back to look at a few twitter exchanges I had at the time and clearly had some issues with the program.

So what changed and why I am now launching a syndicate?

1. I got over it.  In looking at how syndicates have developed, there have been a lot of positives for both angels and entrepreneurs.  Some syndicate leads have gotten allocations in competitive deals where angels wouldn't have had the opportunity to invest previously.  Some are able to offer better terms (pro-rata rights, lower valuation caps) than an individual could get.
2. It's great for entrepreneurs!  A syndicate is very effective and efficient way to raise capital.  In addition to the syndicate participants who can potentially add value, AngelList has its own institutional funds that often participate.  In addition, the entrepreneur has only one investment entity on its cap table rather than a long list of individual angels.  This offers many of the benefits of angel groups (larger investment, breadth of experience, single entity) without many of the negatives (long process, lack of transparency, etc.)
3. I'm still not totally on board with the 15-20% carry most syndicates are charging (still stuck with that golden rule).  This is why I am taking 0% (yes you heard that right, 0%) on my syndicate.  There will still be a 5% carry charged that goes to AngelList, but I'm good with that. They have build a great platform and should be compensated for the marketing, administration, etc.

I'm sure your next question is how can I jump aboard?  Well, the train just pulled in to the station and isn't leaving just yet.  I expect to announce the first two opportunities this month.  You can learn more about the Steve Bennet (aka "ProfessorVC") syndicate here.

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.

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

Was Launch the right platform to Launch?

While the rest of Silicon Valley is slamming drinks at SXSW in Austin and trying out the mobile app Bang with Friends, I'm sitting in my office thinking about last week's Launch Festival.  Seriously, Bang with Friends?? We decided to launch SocialParent at the conference (full disclosure: I'm an adviser, part-time CFO and investor). 

SocialParent is a social network for those who have moved beyond the Bang with Friends stage, have settled down, had a family and are looking for a social network that mirrors their real life social network.

 
 My proposed tagline for the company was "Powering the Modern Family" (with pic below), but the CEO (Reza Raji) shot that one down and reminded me that I was the CFO and not in charge of marketing.  I do love the tv show, but if they all used SocialParent, they wouldn't get involved with nearly as many predicaments as they would be on top of their schedules and where the rest of the family was at any given time.

(For more info download the app or listen to SocialParent CEO explain the service on PandoDaily below).

The founding duo of SocialParent (Reza Raji and Gerry Gutt) were also co-founders of iControl Networks, where I was also an investor and part-time CFO.  We used the DEMO conference in 2005 as the launch vehicle for iControl and got me thinking about how the seed funding landscape has changed in the past eight years.


In 2005, incubators were thought of as either bubble era disasters or university science projects.  The term accelerator wasn't in the vernacular and YCombinator had yet to set their first class free.  First Round Capital (one of the early entrants in the post bubble seed/micro VC funding category) was just getting going and it's primary focus was investing in companies coming out of DEMO.  The term "super angel" had yet been coined, and Naval and Nivi were several years away from sending out the first interesting deals email which ultimately became AngelList.  Demo days were weeks spent hiking up and down Sand Hill Road not a single afternoon when you can pitch to 150 angel investors and VC's. 

When we launched iControl at DEMO in 2005, the conference was not the only show in town, but was definitely a big deal.  Investors and press would flock to the desert to see future hot startups unwrap their products and mature tech companies show off their latest and greatest.  It was expensive ($20K+) but no better way to get major mainstream and tech press coverage, not to mention interest from venture capitalists.  6 minutes on stage were truly a CEO's 15 minutes of fame. There was a ton of energy, great networking and the jam sessions were epic!

The next time I went to DEMO was 2010 and it had moved from a nice resort in Scottsdale, to a Hyatt Hotel in Santa Clara, right in the middle of Silicon Valley.  The energy level was much lower, the startups less interesting, and the jam session gone...I've found through the years that conferences are much better when attendees aren't stopping by between the office and meetings.  I wrote a post forecasting the demise of the conference, Are DEMO's days numbered?  I'm surprised it is still around in 2013, but am sure the selectivity criteria has changed to whoever is willing to pay.

The Launch Festival was Jason Calacanis' response to the pay-to-play of DEMO and other similar conferences.  Launch is a bit of an entrepreneurial orgy (not in a Bang with Friends kind of way).  It is held at the San Francisco Design Center (125,000 sf), had over 5,000 attendees, a massive Hackathon up in the loft, demo pit with over 150 companies, and a cavernous hall where the entrepreneurs took to the stage and Jason held fireside chats with a number of interesting entrepreneurs and investors.  I had the opportunity to judge the Hackathon and was blown away by what the teams were able to build over a weekend.  The winning team (WizzyWig) flew in from Pittsburgh and walked away with over $100K in cash prizes!

While the investors and press made up a relatively small number of the attendees, the overall vibe of the conference was great.  One new addition to the conference was a crowdfunding simulation in partnership with MicroVentures.  I imagine the original intent was to make this real, but with the SEC dragging their feet, this provision of the JOBs Act is far from final.  The simulation was interesting, and was glad to see SocialParent finish on top of the leaderboard.

Hopefully, we can turn that fake investment to real financing.  You can watch the real investment meter go up on AngelList

Back to my original question on whether the Launch Festival is the right platform to launch your start-up.  It obviously depends on a number of factors, one of which is timing.  At a conference held once a year, this is clearly important.  For SocialParent, timing was good.  Also, as experienced entrepreneurs, an accelerator program wasn't that appealing.  For many entrepreneurs, you'll get more investor traction and press coverage out of a YCombinator, 500 Startups or AngelPad demo day.

However, I definitely look forward to Launch 2014.  I hear Jason is looking for a bigger venue.  I wouldn't doubt him and perhaps he can even give those folks in Washington a nudge to make the crowdfunding real next year.

Democratization of Angel Investing

I had a conversation recently with Alex Mittal, Co-founder and CEO of FundersClub (FC) and decided to revisit my blog post from last fall that was skeptical of crowdfunding for angel investments.  FC is the latest Kickstarter type site to launch to give entrepreneurs the opportunity to raise financing from a large number of individuals.  Some of the current services act on the investment bank model and either facilitate transactions between investors and companies (i.e. Micro Ventures) or provide a secondary marketing between investors (i.e. Second Market). 

FC's approach is much more akin to the deal flow and social proof model of AngelList, with the ability to make small investments in a number of companies.  Since the provisions of the JOBS Act relating to angel investments by non-accredited investors haven't been finalized yet, these platforms are currently only available to accredited investors, who already have the ability to make angel investments.  However, there are many pieces of the FC model that are intriguing.

First, a little background on the company.  FC is a YCombinator (YC) company in the current Summer '12 class that will be pitching at next Tuesday's Demo Day. The site has recently launched and all of the 6 companies on FC are part of the same YC cohort.  Only one transaction has closed to date.  Surprise! Surprise! It is FundersClub, so good to see they are eating their own dog food, in VC parlance.

In many respects, the service is similar to the way Angel Groups operate, or at least the way Sand Hill Angels, where I was a long time member does.  Individuals pool their cash in to a single purpose entity to make the investment in the company.  Individuals can make smaller investments in a number of companies, gaining portfolio diversification benefits.  And the company has only one investor on the cap table but can (if they wish) take advantage of a larger group network. On FC, you can see who else is investing, invest with a few clicks, and see how the round is coming together by viewing a real time thermometer. Very cool!  I had always thought AngelList would go in this direction and this indeed may be on their roadmap.  You can connect to FC through Facebook and LinkedIn, but not AngelList...Investors pay a one-time 12% administration fee on top of the investment amount.  This may seem steep, but is certainly cheaper than the annual 2% management fee and 20% carry of a typical venture fund.  Of course, this is comparing apples to oranges.

One of FC's goals is to expand the pool of investors.  While I will be attending the YC Demo Day next week along with many other Silicon Valley Angels, this is not a public event and difficult to attend for those out of the area.  Anyone can now have access to many of the highly competitive investment opportunities.  In addition, the angel investment process can be time consuming and daunting to those not familiar with venture deal terms.  Now, if you wish, you can make investments as small as $1,000 in several companies in a matter of minutes.

I'm curious as to how the SEC will view FC.  The site was designed with the very simple registration process we are all demanding, including checking a couple of boxes to prove you are an accredited investor.  It is no more difficult to move through this than all of the under 13-year olds who have facebook profiles by checking that they are 13 or up.  I'm guessing (if FC proves successful) that there will be unsophisticated unaccredited investors making investments and that the SEC may see this as a public offering of securities. On SecondMarket, there is a much more rigorous interview process and an electronic signature is required.

I still don't see FC as a place I'll make many investments and the administrative fee seems like it will have a material impact on returns, but could prove a great way to have your own angel investment portfolio with aggregate investment amount of $50K instead of $500K-$1M.  Jury is still out, but I'm excited to track their progress and am optimistic that there will be a successful angel investment crowdfunding platform. 

I wouldn't bet against FundersClub.  Unfortunately, I can't bet on them.  I was on vacation last week and missed out on investing in FundersClub through FundersClub before the opportunity closed.  Perhaps, there will still be an opportunity to invest the old fashioned way, but signing a bunch of docs and writing a check. 

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.

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.

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...

How Much Diligence is Due...

...Or are investors better just rolling the dice. I've addressed the due diligence question in previous posts, but this came up again in a debate we were having at a recent meeting of the Sand Hill Angels. A blanket statement was made by one of our members that there was a direct correlation between the amount of diligence done and returns on angel investments. And in order to increase our group's returns, one of our goals should be to get more people and man hours involved in the diligence process. I immediately jumped up and called "bullshit"...

I strongly believe (at least for very early stage technology ventures) that you will get diminishing returns and arguably negative returns once you get past an initial threshold of team, product, market and financial diligence. There are so many unknowns at this stage and the only known is that the business model is going to change at least once, or in the current most overused term in the Silicon Valley, there will be a "pivot".

It turns out the statistics related to returns were from an oft cited study on returns to investors in angel groups sponsored by the Angel Capital Association with research by Robert Wiltbank at Willamette University. The research did show that higher returns were earned by investments where more diligence was done. However, the bar was set very low at 20 hours as the determinant whether high or low diligence was performed.




The average number of angels per investment was 6, which pegs the average time at just over three hours per individual. This could include 2 short meetings and a couple of phone calls. Not exactly extensive diligence. This feels about right for an early stage angel investment and no reason that the process needs to drag out for months and even weeks. The key to getting deals done and investing in the best deals is the ability to make quick decisions and this is where angel groups have deservedly earned a bad rap.

This brings me back to a post a wrote about a year ago titled "Would a Dart Board Provide Better Returns?" I wrote this right after I had read about a new fund, Right Side Capital, that planned on investing in 100 companies a year without ever meeting the team or vetting the idea. Instead, they are going to rely on an algorithm to select companies. The formula will be based on the founders' experience, schools they attended and other background information to gauge the likelihood of success. So, after my initial reaction of "Are they friggin serious?", I became intrigued by what they were doing and spent several hours with the team and looking into their research. If you want to skip to the end of the story, I ended up becoming an adviser and investing in the management company.

So, what ended up causing this about face? Part of it was the out of the box thinking and turning the typical venture investment thesis upside down. You can find a collection of their research on their site and some compelling analysis by RCSM partner Kevin Dick on his Emergent Fool Blog, "You Can't Pick Winners at the Seed Stage" Through their research, they came to two Big Realizations:

1. People matter ideas do not - It is impossible to try and pick the best ideas and if you do, you will invariably screen out revolutionary ideas as crazy
2. The market's risk can be mitigated without reducing the return - This is really basic diversification theory on steroids, that instead or requiring a basket of 20 public equities as you would in a typical asset allocation strategy, in the seed stage you need hundreds of investments, which will smooth the risk curve
   

Kevin quotes early and often from the Black Swan by Nassim Nicholas Taleb




Black Swan Theory, according to Taleb, almost all major discoveries and undirected and unpredictable. In the context of angel investing, the best way to play is to diversify across a broad spectrum of technologies and geographies. Since it is extremely difficult to predict, this will give the best chance of hitting the winners.

Not totally surprising, some of the early backers of RCSM are professional poker players, who obviously know a bit about playing the odds. I'm hoping this roll of the dice comes up 7's.

Angie's List or AngelList?

An excellent question to ponder as the school year begins, but the answer depends on whether you are looking for a plumber or an angel investor.

The fall semester at SJSU started this week and had the first class meeting of my Entrepreneurial Finance class, which was overflowing with students standing, sitting on the floor and begging to get in. I'd like to think that work of my excellent teaching has made it's way around campus or that the Entrepreneurial fervor has reached new heights, but I've seen my ratings on Rate My Professor. Still wondering who that student was loved the course, but said I was a dork with a voice like Steven Hawkins. More likely the reality is that many students are trying to fill that last elective to graduate, which has not been easy with all of the budget cuts resulting in fewer class offerings.

Many of my students are finance majors, so I spend the first class with a (very) brief corporate finance review with the hint that very little applies to start-up finance. In corporate finance, students are taught that capital markets are efficient and this is an underlying assumption for valuing stocks, bonds and other financial instruments. The theory states that all ifnormation is publicy available and it is not possible to earn returns above average on a risk-adjusted basis. Whether you buy this or not for public equities, the market for early stage private companies has always been wildly inefficient. Entrepreneurs struggle to find investors and investors struggle to find the best start-ups. When they do, it is often a competitive situation and the hot start-ups end up oversubscribed and instad of adjusting price and other terms to optimize the deal, they are forced to leave some interested parties out.

While VC firms have been easy to find from the old school days of Pratt's Guide to Venture Capital, to the early web presence of the 1990's and the current web sites, blogs, twitter feeds, facebook fan pages and sites such as The Funded, angels are still a bit harder to track down. We do have certain angels aggressively marketing themselves (Good to see my former student, Dave McClure, making a name for himself as part of the PayPal Mafia and "Super Angel" crowd), many others have no interest in publicizing their net worth or investing activities.

According to the Center for Venture Research at UNH, there are over 260,000 angel investors. How the hell are you going to find and ptich the one who is going to invest in your deal??? These angels invested $17.6 billion in 2009, which matches the amount invested by VC's. However, angels invested in 57,225 ventures vs. 2,795 for VC's. It goes without saying that a much higher percentage of the angels deals are seed than VC, so you are likely looking at a 1 in 50 shot of getting your company's initial funding from VC's vs. angels (if you are among those that are able to raise either!). And the 1 in 50 is a team that has already made that VC money. While the supply-demand equation will never be completely fixed, the information and accessibility to angel investors is only getting better.

There are several efforts being made to make this process better and will mention a couple below:

• Angel Capital Association Collaboration Committee - I was a charter member of the this group and the goal is to facilitate syndication among the angel groups via education and tools such as Angelsoft. One of the issues in angel group investing is that any one group often doesn't have the investor interest level to provide the total capital required for a round. At Sand Hill Angels, our initial investments are in the $100 - $500K range and rounds are typically $500K - $1.5M. The goal of cooperation is theoretically very interesting, but practically difficult. There tends to be a strong groupthink mentality in the angel groups, and once one group has decided to invest, the others still need to run through their process, which can take weeks to months. This is a brutal process for entrepreneurs and many have no interest in the angel groups for this reason. At SHA, we have instituted a fast track process where companies that have already lined up committed investors (including some SHA members), can expedite the process. We recently led a financing for AppBistro, that had a great group of investors committed, including Dave McClure and Alfred Lin. I joined the board and am looking forward to working closely with the team.
  

• The AngelList - a service where entrepreneurs can connect with angel investors an dangels can share interesting opportunities with other angels. I recently became aware of this list and just joined and have started reviewing some of the start-ups and looks like an excellent resource for both entrepenurs and investors. I'll follow-up in a future post on how it has worked for me.

Now back to the original question posed in the title. For angel funding, my choice would definitely be AngelList. Of course, if you are looking for a plumber, Angie's list would be better. However, you never know, you might find a start-up that has a cool mobile app to fix your leaky faucet...

CFO's - More Guardian, Less Angel?

Just received this month's issue of CFO Magazine (yes, I know, it should be a very exciting weekend) and found an article I was interviewed for a couple of months ago. The article, "More Guardian, Less Angel" discusses how CFO's add value to angel groups by helping to kill deals. I spent most of the time with the reporter talking about Sand Hill Angels and how we add value to the start-ups and entrepreneurs that we partner with, which is why I just have a small mention in the article.

It is certainly true that we can pick apart the financial projections or pour through contracts, legal and financial diligence, but none of those areas tend to be the most important areas in deciding whether to make an early stage investment. No company's future ever matches their projections and it is the assumptions and how the entrepreneur understands the market and sees the opportunity evolving that we care about.

As I am quoted in the article, it is easy to pick holes in a business plan. It is certainly good to take an analytical approach to any investment opportunity and many venture capital firms and angel groups do an excellent job of diligence. However, at the end of the day, your gut can tell you a lot more about whether to make an investment or not. How passionate are the entrepreneurs about their business? Can they recruit and get others excited? Do I believe they can succeed? Does the business model pass the smell test?

While no real data exists on returns in angel groups vs. individual angels, I often wonder which is the better way to invest. I enjoy my colleagues at Sand Hill Angels and like investing as a group as it enables us to lead investments, take board seats and have more influence. The downside is the groupthink mentality, which can work in both directions, killing deals and also creating a bandwagon effect. In a lot of our deals, there is often a tipping point where the deal will either move forward or die.

Even though I am an active member of an angel group, I often advise entrepreneurs that they may be better off raising money from individual angels rather than groups. A lot is based on how much money they are raising, terms being sought, entrepreneur's experience, stage and total funding required for the business. I'm going to do some more thinking on this topic and write another post sometime in the near future.

Buyer's Remorse

Wikipedia (where else would you look....) defines Buyer's Remorse as "an emotional condition whereby a person feels remorse or regret after a purchase" and "a natural human reaction, rising out of a sense of caution". I certainly remember the feeling after buying my first house. The feeling is fleeting and then you go about making the house into your home.

I have noticed this same feeling when making a venture capital or angel investment. While spending time with the entrepreneurs and championing the deal through the group, you tend to become emotionally attached. Of course, rigorous diligence is performed, the team is challenged, and assumptions are tested. Once the point is reached where you want to move ahead, we put the sales hat on and convince our partners about the incredible opportunity that we are lucky enough to be able to invest on the ground floor. However, once the deal is completed and the wire hits the start-ups bank account, all the warts seem to jump out. In most cases, the entrepreneur hasn't hidden anything, it is just buyer's remorse kicking in and the realization that the hard work is beginning. As early stage investors, our goal is to eliminate as much risk as possible with the least amount of cash spent.

Of course, the opposite of buyer's remorse is exercising too much caution and not making an investment where your gut was saying yes. I've found that the opportunities we let pass often stick around longer than many that we do. I started thinking about this yesterday when Jeff Fluhr, founder of Stub Hub spoke at my San Jose State class. I first met Jeff about 8 years ago when he was finishing his first year at the Stanford GSB and was beginning to raise money for a business plan he developed for a secondary market ticket exchange. This was the beginning of the dot com bust and getting a consumer deal through the partners at my venture firm was next to impossible. I liked the founders and considered making a personal investment, but ended up passing.

However, I was glad to see they were able to raise financing and launch the service. I used it as a buyer and seller on a number of occasions and rooted from the sidelines for their success against the Ticketmaster, state regulators and others trying to knock them down. Jeff was able to build a profitable company and a successful exit when Ebay acquired Stub Hub for $300 million early last year. Jeff shared some entrepreneurial lessons with the class and I may include in a subsequent blog post.

Of course, I'm not the only one to feel this way. I was listening to a podcast recently on Venture Voice with legendary VC Tom Perkins. When asked the question about the worst investment he ever made, he turned it around to mention the one that got away, Apple. Kleiner Perkins had looked at a few other computer start-ups and weren't interested, so didn't even take a meeting with the Steves. Bessemer Venture Partners lists an anti-portfolio of investments they passed on that includes Apple, Ebay, Intel, and Google.

Now, back to that house in Mountain View, California. Hard to believe you could buy a nice house like that in the Bay Area for only $300,000....