Month: July 2008

Jul 30 2008

How Can I Invest In A Venture Capital Firm?

Q: Your site talks a lot about VCs investing into companies but I can’t find any information online (even on the VCs websites) about how VCs solicit investors to their funds.

I want to invest with a VC but I don’t know what is the minimum VCs accept. Who in the firm should I contact to invest? What kind of terms should I expect? What kind of returns does an investor normally expect? How soon would I get my money back with the profit? Would I be in a position to make demands and say "I want a fourth of my investments to go to XYZ company that is looking for VC funding"? etc.

A:  (Jason) Most venture firms do not take individuals as investors unless they have a pre-existing relationship with them.  Most VC investors are institutions, endowments, pension funds and other corporate entities that professionally and regularly invest in VC funds  As an individual, your best way of investing is either through high net worth family office organizations or through your financial broker, if they participate in these types of offerings.  Because of this, and because of securities laws that I won’t bore you with, you’ll never find information on VC websites on how to invest. 

As for your ability to control terms or designate investment particulars, this probably won’t happen.  The large institutions that invest in funds drive terms, not individuals, so if you do decide to invest, you’ll piggyback off the terms the VC fund and it’s largest investors negotiate. 

Jul 30 2008

Am I In Trouble If I Don’t Raise Money From Kleiner?

Q: It seems that the venture community is dominated by a very few large names (Kleiner, Sequoia, etc.).  If I don’t get funded from one of those firms, is my company toast?

A: (Jason)  Nope!  While Kleiner and Sequoia deserve their great reputations, the list of successful venture backed companies that had syndicates that didn’t include either Kleiner or Sequoia is extremely long.   While having a great VC firm as an investor is often very helpful, the idea that you are “toast” if you don’t have an investment from one of them in nonsense. 

The real key is finding a partner at one of these firms who understands your business and whom you think you’ll have a great working relationship with.

Jul 29 2008

Should I Pay My Venture Capitalist To Consult For My Company?

Q:  My company is backed by VC firm to whom we also pay a $2k/month "consulting fee." We have raised approximately $2MM from them in a Series A. Is that type of consulting payment typical in an early stage venture?

A:  (Jason)  I want to vomit again.  We received this question just a  few short days after posting that entrepreneurs should NOT pay their lawyers for introductions to VCs and how scummy of a practice that was.

Now today, we get this question.  This is even worse.  The answer is NO.  Companies should never pay their VCs consulting fees, board attendance fees, or any type of fees related to their involvement in their company.  I’ve never worked with a reputable VC firm that charges their companies to help them succeed.

As a venture capitalist, we are paid a management fee by our investors that is our "salary" and we receive a percentage of the profits (called "carry") on our fund.  We don’t get paid to sit on boards and certainly it is not appropriate for them to "round trip" your investment capital by paying themselves part of it. I would wager to guess if their investors knew they were doing this that the investors would revolt.

I’m sorry to report, but not only is this not typical, it’s unheard of in the venture world when dealing with reputable folks.

(Note, private equity is a totally different matter and fees are commonplace, but it’s a totally different model)

Jul 29 2008

What Is The Purpose of Venture Debt At The Series A Round?

Q: From my limited perspective, venture debt in proximity to an A round seems awfully premature — restrictive debt coverage ratios, warrant coverage on preferred terms, etc — yet there seems to be an awful lot of venture debt investors out there who essentially have no response to these concerns but want me to take their money anyway. Hence my question: if such financing really is premature and potentially limits the options for a startup, why should an early stage company take it?

A: (Brad) From a tech entrepreneurs perspective, there are two types of banks in the world.  Those that understand tech entrepreneurship and those that don’t.  Those that do – such as Silicon Valley Bank and Square 1 Bank – have good early stage venture debt programs.  Those that don’t either simply don’t have a venture debt program or have transient ones that come and go with the market.

Let’s assume we are dealing with a credible bank in the context of venture debt. These banks have venture debt programs that are largely based on their relationships with the VC firms involved.  The ultimate goal of the bank is the long term relationship with the company – they are willing to extend debt on relatively inexpensive terms if they believe the equity participants (the VCs) are going to be supportive of the company beyond the Series A.

Now, the price of admission for this for the bank – and for the banking relationship – is to extend debt terms as part of a banking package.  This package will have all the expected banking services, but will also include either an unrestricted debt line (usually somewhere between $1m and $2m) and an asset-based line (usually up to $1m).  This debt package will have straightforward terms, including relatively light warrant coverage so the bank can get some upside in the success scenario.

The bank is doing this because it believes the VCs will continue to finance the company beyond the Series A.  This debt will typically give the company one or two quarters of additional runway to make progress which can be very helpful in the context of some early stage companies. 

One thing to be cautious of is a debt package that you can’t actually use.  Many proposals have covenants in them that essentially require there to be an equivalent amount of money in the bank as the debt being borrowed – this is obviously useless.  However, I continue to be endlessly entertained by the proposals like this that I see.

Jul 24 2008

Should I Pay My Lawyer A Success Fee For Venture Capital Intros?

Q: My lawyer is asking for a "success fee" for a referral to a potential investor in my business. Since he’ll be doing the legal work, he’s offered to charge only 3% on the amount funded (solely from this one contact) as opposed to a 5% that a typical investment banker would charge (even though he’s not an investment banker himself).

As this is the first venture I’m actually raising capital for, I am simply unfamiliar with this practice in the legal world. Is this a common industry-wide practice? Should I be wary of this offer? Although I don’t feel like he is trying to take advantage of me in any way, it does feel a bit like he’s trying to double-dip.

A: (Jason)  Without sounding too unprofessional, I want to vomit.  This is egregious behavior by your lawyer and you should not accept paying ANYTHING to him for introducing you to potential investors.

First of all, it’s part of a lawyer’s job to introduce you to any investor contacts he may have.  If you get funded, he gets paid and gets to bill you throughout the lifetime of your company.  If you don’t think he is already making enough money, see my post on start-up lawyer compensation from my personal blog. 

Second, while investment banks may offer you a deal at 5% (and in my experience this can be negotiated down), individuals who find money for you (normally called "Finders") normally charge in the 1-2% range, so his quote is at least 50% too high.

Lastly, venture capitalists prefer to invest in deals without finders.  We don’t like funding a company that has to pay someone part of the deal proceeds.  We want our money to be used to operate and grow the company.  You will see many VC term sheets that have provisions that specifically call out the absence of finders fees. 

So yes, your lawyer is double dipping.  And that is stating it very nicely. 

Jul 22 2008

Are Eyeballs Good Enough?

Q: In the era of "free" software, would a mobile software startup be committing short-sighted suicide by attempting to price their product at all? These days, it seems that "eyeballs" are considerably more valued than short-term monetization.  Facebook being a prime example:  they avg a mere $3.00 in gross revs per active user annually, but yet they hold a $15B valuation. Within the VC community, how much weight does the "build it now – figure out a way to monetize later" type model still hold? Are you seeing any trends of push-back against this model?

A: (Brad) There was a time not so long ago (1999) when it didn’t matter how much revenue you had, or how much money you made (or more likely – lost) – all that mattered was how many eyeballs you had (and how fast that number was growing.)  If I remember correctly, that cycle didn’t end too well.

While there are plenty of different things going on this time around, ultimately all businesses have to generate a profit (and positive cash flow) to be valuable.  But that’s the not the question you asked.

These days, it seems that "eyeballs" are considerably more valued than short-term monetization.  The key word in this statement is "short-term".  In the short-term, it’s important that you get enough critical mass behind your mobile app and this generally means users.  However, with the emergence of the iPhone App Store and the crazy disruption it and the iPhone are having on the mobile phone and software market, I’d assert that all bets are off right now on what the best "short-term" strategy is. 

For example, I’m aware of several very popular iPhone apps that are free; I’m also aware of several that generated significant revenue in the first week for their publishers. 

Ultimately, if Apple is successful, it will help establish a new market price points for mobile apps that will range from "free" to "something".  I don’t think anyone knows what that range is yet, but it’s not going to be "free" to "free".  And – as a result, you shouldn’t view pricing your app as "short-sighted suicide", unless of course you price your app too high (where – in many cases – the max price you can charge is nothing.) 

I’d be a lot more worried about having an app that no one cares about.

Jul 4 2008

Intent, Term Sheets, and Off Limit Questions

Rick Segal has three great blog posts up this 4th of July weekend.  He’s Canadian so I expect he is still working – maybe we’ll see a fourth from him.

Happy 4th Rick.  Keep writing.