Month: January 2007
Question: How do you find a good law firm? Which one’s can help me get in touch with VCs?
Our Take: There are many good law firms out there doing start up work. What used to be seen as solely a costal practice, has now permeated through out the country. Most major cities have at least one law firm that has the requisite experience to help you. The best referrals are from friends who have used particular attorneys. Most folks are quite open about their opinions. The key questions to ask are: “how many companies have you worked with that are now venture backed and weren’t so when you began working with them? How many venture capital (versus hedge or private equity) deals have you done in the last year? Does your firm have a dedicated startup practice, or is this just a “side business?” I’d also tell you that doing venture capital law isn’t rocket science, so if you get someone being too boastful, or putting down his / her competitors, they clearly are bragging more than it is warranted. The most important part of being a venture capital lawyer is being a good listener with sound judgment and having a good relationship with the entrepreneurs, along with the requisite experience. Make sure with whomever you choose, that you see them as a true partner, not an hourly paid servant.
As for which law firms can help you connect to VCs, again, there is good news. Ten years ago, or so, it was seemingly rare for law firms to have a close enough connection to get your business plan in front of a VC. Maybe they could send over the business plan, but the regular experience was that they usually entered a “black hole.” These days, I think VCs are more open to really looking at business plans submitted by their law firm partners. One thing that is certain: law firms that do VC fund formation work definitely have good contacts to VCs. So if you are looking for your lawyers to make some intros, you can never go wrong with a law firm that helps form the VC funds themselves.
Today’s great VC blog of the day comes from Matt McCall who writes about The Myth of 51%. As most early stage entrepreneurs know, the notion of “control” is an elusive one that ultimately kicks in when your company starts generating positive cash flow and you no longer need any capital from your investors. As Matt eloquently points out – it’s all about mutual respect, alignment of interests and cash flow.
Question: How important is speaking to product management to a VC? While most do not sit on the management team, do you like to interact with them regularly?
Our Take: Absolutely. VCs like to interact with all major functional heads of the company whether they are operations, finance, engineering, marketing, sales, product development and management, etc. It’s important for an investor to see the company from the eyes of many different touch points, not just those of the CEO and CFO. This in no way is meant to undermine the authority of the CEO, or to intimate that the CEO isn’t trusted, rather in a well-performing, functional management company, it is good to evaluate diversity of opinions.
I find that the board meetings that are most useful always contain some in depth discussion from one or more functional areas of the company. These aren’t always the same for every meeting. If the company is about to release a new version of the product, I fully expect and want to speak to the engineering team. If the company is getting ready for fundraising, we’ll spend more time with the finance folks. Along these lines it’s really helpful to talk to product management folks about their vision of the future, how customers are accepting their products and how the integration between them, sales, businesses develop and engineering works.
Question: A partner and I have presented a business opportunity to a private investor. After significant due diligence on both sides, and agreement in principle of terms, the investor has requested for us to present a term sheet. Where do I go from here?
Our Take: It’s somewhat irregular for the company to issue the term sheet to the investors – usually, it’s the other way around. That being said, it’s always an advantage to be drafting (called “controlling the paper”).
You are going to need 2 things to get this done properly:
1. Good lawyers; and
2. Knowledge of the basic terms.
Regarding the lawyers: you can’t do this yourself. You need / should / must get competant legal counsel on your side. Whatever deal you cut, you will have to live with it “forever.” We can’t stress this enough. Make sure whomever you get has experience in these types of deals.
For your own education, Brad and I did an entire series on Term Sheets a while ago and these posts represent just about everything we know and the tricks that some investors try to get by some companies. Start chronologically, from oldest to newest and we’ll take you through every major provision of a term sheet.
That being said, get a lawyer.
One of the regular questions we get is “how do I become a venture capitalist.” As there isn’t a well defined industry standard job description for “venture capitalist”, we thought it’d be useful to reach into the deep, dark, musty blog archives and reprint a post on How to become a venture capitalist – with minor edits (and Seth’s permission) – that Seth Levine wrote in May 20, 2005.
I get asked this question a lot and while the real answer is “I have absolutely no idea,” I thought I’d make something up here so I at least have a place to send people who ask me this question (as well as anyone else who happens to stumble upon this blog searching for ‘getting a job at a venture capital firm’). This post is for aspiring analysts, associates and principals and has little to do with getting a job as a partner.
Step one: Assume you will not be able to land a job as a venture capitalist. This is the realistic outcome of trying to get a job as a VC. Here in the Denver market I can count on one hand the number of VC jobs that have opened up since I joined Mobius in 2001. Only a couple (I’m thinking about two at the moment, but there may be a few others) actually went to people who weren’t already in the industry. Even in larger VC markets (specifically the Bay Area and Boston) there are many more people who are actively looking to get into the VC world than there are positions open.
Step two: Understand the math. It’s critical to understand how VC’s make money and therefore the fundamental request you are making when asking for a job as a VC. Venture capitalists make money in two ways – from management fees (a percentage of funds under management) and from carry (a percentage of the return on investment). The partners of the fund use the management fee to pay the expenses of running the business (office space, technical infrastructure, travel, support, etc.) and then pay themselves with what’s left over. As a non-partner you are fundamentally a cost center. The partners are quite literally taking money out of their own pockets and giving it to you. Rationally, they will only do this for one of two reasons – either you are significantly impacting their lives in a positive way that makes the trade-off worthwhile for them (you cost less than the marginal life benefit they get from having you around) and/or you will help create more carry (i.e., they can manage more deals with you around and therefore deploy more capital; you have a skill set that will positively affects the portfolio, etc.). If you fail to do these things you are just eating up management fees. There is a grey area here for Principals (called VP’s or SVP’s at some shops, junior partners at others) who are managing their own deals as well as supporting partners’ deals.
Step three: Get close to VC’s. The road to becoming a VC follows many different paths, but fundamentally your first step in landing a VC gig is likely to be figuring out who the VCs are in your area and trying to get close to them. If you’re still in college, consider a job in an investment bank or other financial services firm (even VC analyst jobs are hard to come by straight out of college – VCs tend to hire people with at least some financial training at those levels) to get the best possible training for an entry level job in VC. If you are in business school, look for internships that will allow you to meet venture capitalists (either at a VC directly or for a portfolio company of a VC). If you don’t fit any of those categories, take a job at a company backed by venture money and try to get exposure to the venture capitalists on the company’s board. In short do what you can to get to know VCs in your area so that when a position opens up you can be both top of mind and a known commodity. Take a longer term view of your approach and remember that many VCs got there not by following a traditional path (banking –> b-school –> VC) but have years of operating experience, were entrepreneurs themselves, or were somehow else involved in the business of building and growing companies.
Step four. Be smart about networking. I wrote a separate post on the subject of smart networking, but suffice it to say here that you should put some thought in how you use your network to meet VCs. Figure out who you know who also knows VCs that you’d like to meet and play the network game as best you can. It can take a long long time to get meetings set up – be patient about it (Brad probably doesn’t remember this, but when I was first introduced to him in what was a very ‘hot’ introduction from someone who he trusted a lot and who had worked very closely with me, it took three months to actually get in to see him.)
Step five: Don’t get discouraged. If you remember back to step one, you weren’t going to be successful getting a job in VC in the first place, so all the progress you are making is gravy, right?!?
Question: How does the VC community deal with open source? I am working on an embedded device that can be built either way, open or closed. This decision is complicated since our group (due to past successes) is capable of funding the first few rounds internally. We won’t need external VC until the last round in order to enable full production. Which product would the VC rather see, SlimDevices (completely open) or the Zune (completely closed)? Actual product is neither of those devices. Is the creation of a user/hacker community worth the exposure of having the source code open? What does a VC perceive as the downsides of open source?
Before I take a crack at this, I want to point you to an excellent post that Will Price at Hummer Winblad posted yesterday – The Three Most Important Letters in Open Source: CYA.
Like most things in software – some VCs get it and some VCs don’t. Now that open source has become mainstream – initially through the commercialization of Linux but also the success of VC-backed companies like RedHat, JBoss, and MySQL – there is real history and precedent around how to create a successful open source company. In addition, there are a set of VCs (think “individual partners, not firms”) that have a positive track record helping fund and build open source companies.
There are several different layers to the issue. The first is the most basic – many companies use open source components as part of their proprietary products. Several years ago VCs and entrepreneurs got tuned into the risks associated with this due to several absurd lawsuits – such as the SCO / IBM one – that created an uncertain potential future liability for these companies, their customers, and any larger company that acquired them. As a result, there was an immediate irrational buyer backlash against open source – we sold several companies to large public company acquirers that had very tortured negotiations around their open source IP – usually resulting in unnecessarily complex IP representations in the purchase agreement, actually code modification as a condition to closing, or fundamental challenges in getting a deal done. As people began to understand the liability dynamics better and products for evaluating source code for open source emerged (including several that are VC backed), this started to settle down and today is in a much more rational zone.
Next is the actual creation of commercial company around an open source product. Many successful open source products have a small number of key architects (and often one “king of the project.”) A relatively small set of people have figured out how to effectively commercialize the companies and – as a result – you’ve seen some impressive businesses built around open source projects. The key phrase here is “a relatively small set of people” – the vast majority of software VCs don’t really understand open source in any great depth – especially when you get into the intersection of community, legal, and commercialization issues. As an entrepreneur – this is yet another case where you should make sure you are filtering your potential universe of funders carefully and trying to evaluate early whether or not someone will get it.
The question asks very directly “what’s the downside” and “is the creation of a user / hacker community worth the exposure of having the source code open.” These are tough questions to answer because they are circumstantial in nature – most commercialized open source projects either emerge from (a) an existing open source project that becomes popular and reaches some critical mass or (b) a specific product that has a software component that can be enhanced by active user involvement in the build / development of it. Companies in category (b) are particularly interesting, as they have open source software as a strategy component of their business, usually driving commercialization theme that is attached to the software (e.g. a hardware device that is user configurable / programmable.)
Open source is undeniably here to stay and a critical part of the software ecosystem. However, as the question forshadows, even though open source (and its father – “free software”) has been around for a while, the mainstream software industry is still wrestling with many issues surrounding it and we expect they will continue to for a while. Herein lies great opportunities for entrepreneurs and investors.
One of the questions that we get the most is “How many percentage points of my equity should I give to a VC wanting to invest X dollars in my company?”
The answer definitely falls into the “it depends” category, but our friends at Cooley Godward Kronish have a great report on what some general guidelines are.
Every so often the publish a “state of the market of VC” report. If you go here, you will see their publications. Check out the September 2006 update. It has a great analysis of the costs of raising capital. They also let me know that their February report will be out shortly.
One other thing. I can’t seem to get this to work with Firefox, so take under advisement.
Question: We have recently discovered that our business partner is an alcoholic. He is integral to our business and we need to find him help. He’s been to a couple of AA meetings, but doesn’t like the “atmosphere.” Any recommendations? I don’t expect you to provide recommendations for treatment facilities. However I am interested in knowing how an entrepreneur should handle a situation in which s/he feels that in the best interests of the company, a key partner/executive/investor should exit or transition into another role for whatever reason. What evaluation process should the entrepreneur go through before making a final decision? How do you recommend the entrepreneur approach that person and with what type of exit or transition strategy?
Our Take: This is a very unfortunate and sensitive matter. Besides the personal issues, there are also business and legal considerations to address and we can not urge you strongly enough to speak to your lawyer, as state law can drastically change your options. Normally, either Brad or I answer questions posed to us, but for this post, both of us will respond, Brad highlighting the business side and Jason addressing the legal.
Brad’s Take: I am no expert on alcoholism. However, I have had several friends that either became alcoholics or drug addicts. In each case, their addiction dramatically decreased their ability to function in a business context over a period of time until it reached a point where they had a meaningful negative impact on the business they were involved in. These were both tragic situations – there were deep personal relationships that were shattered as a result of the stress, tension, and dynamics of the relationships around the addiction. As a result I only know one way to deal with this in a business context – head on and directly. As a human, I believe I am responsible for my actions and you are responsible for your actions. All actions have implications and part of being a person, being business partners, and being friends is that you have to deal with the implications of your respective actions. While your personal philosophy may be different than mine, I felt the only way to answer this question from a business perspective was to start with my philosophical frame of reference.
If you share my perspective, I’d recommend having a direct and very difficult conversation with your partner. I’d do it in a non-confrontational manner – in a comfortable setting – with the backdrop of your fundamental concerns. In this case, it appears that your partner acknowledges his addiction, which is a great start. I’d offer any and all help I could – and be as flexible as possible – within the context of reasonableness – to help him find help. If AA doesn’t work for him, I’d help him find alternative programs, including such things as therapy and in-patient treatment for addictions. But I’d insist that he address the issue as a part of staying involved with the business. If he was unwilling to do this and his addiction impaired his ability to be effective, I’d immediately confront the issue of him departing the business if he was unwilling to address the issue and get help. I would not be judgemental in any way – in fact I’d acknowledge that I wanted to do everything in my power to be supportive and helpful – but insist on dealing with it in the context of the business. In my experience, one of the most challenging things for someone that has an addiction to deal with are limits on their behavior, especially in the context of the addiction. While it sucks to have to be the person that draws the lines in the sand in a situation like this, it’s often necessary.
Jason’s Take: I agree with everything that Brad has said. Unfortunately, if things don’t work out, you may have to consider firing your partner. Depending on where your business resides, you may or may not be able to terminate someone with a substance abuse problem. In some states, you have to allow the person to seek treatment for 30-90 days and hold their position open while they are gone. In the case of a key employee, it can be really tough on a young business to have this person absent from the company and to not have the option to replace them. Even after this treatment period, you then have to give them some reasonable time to re-integrate into the business. If you terminate the individual following treatment, one must always be aware of the potential “retaliatory firing” lawsuit. This is a state-by-state analysis. In some states, you can still fire a person for any reason.
Do note however, that a person with a substance abuse problem can waive their right to seek treatment and instead accept the termination and sign a release. Obviously, there will be a price tag attached to this.
As for an “evaluation process” I’d suggest one of two polar opposites: document everything, have multiple people in each conversation, put the person on notice, offer assistance, etc., or document nothing. The “everything” approach will build the best record and in the event of a lawsuit, hopefully you can prove that you jumped through all the hoops and that the termination wasn’t an unjust termination. The “nothing” approach is more akin to sweeping things under the rug. This would play well if you think you can get a signed release at a reasonable price.
Question: Valuation is often one of the first questions VC’s ask of companies seeking capital. It seems that VC firms have their own way of doing a down and dirty estimate of the companies value. Will you share some of the common “quick ways” they arrive at the companies value?
The short answer is “no – we won’t share common quick ways VCs arrive at companies value – that’s part of the secret VC voodoo magic that we keep secret from entrepreneurs, especially if they are on double secret probation.” Oops – that was mean for the blog www.dontaskthevc.com – I forgot which one I was posting to.
Valuation – especially for early stage companies – falls in the category of “more art than science.” While buyout investors who are acquiring companies with meaningful cash flow streams love their multi-sheet Excel models with 37 pivot tables, most early stage VCs can do valuations on a napkin (or – if they are good at simple math (e.g. addition and subtraction) – in their head.) In the early stages three things drive valuation: (a) ownership dynamics, (b) market terms, and (c) competitive deal dynamics.
Ownership dynamics are the most vague – many VC firms have a view of their “target ownership” of a company (e.g. “we like to own 20% of the companies we invest in”) and use this to back into a valuation. However, the specific amount varies by firm. In addition, most firms – especially larger ones – can simply write bigger checks to get the ownership they want, which results in larger post money (but not always premoney) valuations.
Market terms are a little easier to understand. If you are an early stage company, you’ll start hearing things like “1 on 2” or “3 on 3” or “5 on 4”. “1 on 2” is VC shorthand for “$1m buys 33% of the company.” While market terms move around over time, most seed deals get done between $1m and $3m premoney and most first round investments typically get done where the capital in buys 50% of the company (e.g. “4 on 4” or “5 on 5.”) Again – this is art – there is no scientific way to really value three guys and a powerpoint slide or a web service with 10,000 subscribers of which 250 are active (although no one can prove that only 250 are active.) When you are in this position and your prospective VC starts talking about discounted cash flow in year 10, run screaming from the building – he is not the droid you are looking for.
Competitive deal dynamics are where all of this goes out the window. If you only have one VC interested in your deal, you have relatively little negotiating leverage. However, if you are the hottest company of the week, have a dozen different firms that want to get into your deal, and you have three great angel investors ready to write $500k checks each to fund your first round, you probably can negotiate a meaningfully higher price.
Question: We’re a profitable bootstrap NOT looking for institutional funding. Periodically we get inquiries from VC associates. Is there any reason we should or shouldn’t talk to them? Assuming they have plenty of deal flow, and we haven’t been introduced, why would they even bother?
Our Take: If you are profitable bootstrap company and people know about you, there clearly will be outside interest to get “in the deal.” I’ve seen a few deals like this where they get a “hot” label and everyone starts calling and trying to figure out if the team is taking money. Why they bother is that associates are normally trying to prove their worth, create their network and not let any good deals get past them. It might be a real coup if an associate could get your deal in front of one of his or her partners and look good. As for speaking to them, if you really never intend to raise money, then the only reason that you’d want to meet with them is for the free business feedback. If it’s possible that one day you’ll need expansion capital, you might want to start cultivating some relationships. Whether or not these folks have enough deal flow isn’t really the question (although firms that have less deal flow, certain make unsolicited calls more often), rather there aren’t a ton of profitable companies looking for VC money.