Month: August 2008
Q: Can you please touch on issues associated with first round financings from corporate or strategic investors. Particularly when the strategic is a competitor. What are some of the pitfalls and opportunities associated with this type of an investor in an early stage company?
A: (Jason) There are both potential positives and negatives taking money from a strategic investor. And despite the arguments for and against, there is also are no bright line rules on wether or not you should accept strategic money.
Let us first look to the positives. Usually the biggest perk is the ability for a strategic investor to be able to accelerate and help your business in ways that a venture capitalist can’t. Strategics can offer access to manufacturing capabilities, technical resources, sales channels, foreign joint ventures, guaranteed retail shelve space, etc. The strategic can leverage their business to help you.
Also many strategic investors don’t consider themselves "financial investors" in the same way that venture capitalists do. So while a VC might need to realize a return in 5-8 years and be happy with a certain return, many strategics are deriving other benefits besides the ultimate return. Therefore, they may be a little easier on you if things don’t go quite as planned, so long as they are still deriving utility from the other benefits.
This also can lead to a problem, though. If you investor isn’t ultimately financially motivated to see your company succeed, that can be a conflict between them, you (assuming that you are financially motivated) and any venture investors (who I guarantee are financially motivated). You may find yourself trying to make decisions that will promote one set of interests over the other.
We’ve seen this many times. The questions is "how do I know of my strategic investor is motivated by venture-type returns versus ‘something else?’" Here are some clues:
- If your strategic investor is asking for terms that a venture capitalist would not, such as:
- A right to buy the company / first look / call agreement (which you should never agree to, as this will kill any other potential suitor from speaking to you);
- Warrants / other equity kicker for free or based on services provided to the company;
- Restrictions on who you can sell your product to; or
- As a condition to financing, entering into some sort of business arrangement.
- If you ask them if they are financially motivated and they say no. (Don’t laugh, many will be completely open about this.
To be clear, even if your strategic is not financially motivated, it still might make a ton of sense to take money from them, you just need to weigh the benefits of the "stuff" they bring to the relationship besides money. For instance, a performance-based warrant for true performance may be appropriate.
One thing to consider is a board / observer seat. Most strategics don’t want a board seat as they don’t want the fiduciary duty issues present with their own business and yours. This is especially true if your strategic is a competitor. But they many times will ask for an observer seat and you need to carefully consider what type of information will be in their hands at the end of the day.
A note on competitors investing in your company. I haven’t seen many of these arrangements end well. Usually, the distrust of sending information back and forth quickly chills the relationship. Do you really want your competitor getting your financials and board presentations? Do you want them to know if you are negotiating a deal with one of their other competitors?
In general, we’ve had both good and bad experiences with strategic investors. We’ve had deals that without them, we wouldn’t have had nearly the success that we did. We’ve had deals where we never saw or heard from them again after the funding. We’ve had other cases where the noise in the machine caused by their wake was quite disturbing. In this particular case, it appeared that the strategic’s sole intention was the bankrupt the company and take their technology.
It’s really an individual choice. I’d recommend getting references from prior investments that they’ve made to see how helpful they really can be.
Q: Everyone tells me the way to approach a venture capitalist I don’t know is through a friendly introduction from someone who already knows that VC. But what happens if I don’t have the connections to get that introduction? Am I screwed?
A: (Chris) Every entrepreneur who has raised venture capital has heard it a thousand times—the best way to approach a venture capitalist is via a warm introduction. Venture capitalists invest in people as much as they do in technology or business ideas, and having some connection (even if it’s indirect) is immensely helpful to the VC in determining if that entrepreneur is someone he wants to invest in. The logic also continues that VCs are generally bombarded by requests for meetings, so a warm introduction helps an entrepreneur’s request float to the top of the list.
Unfortunately, as you’ve pointed out, sometime you don’t have the luxury of relying only on warm introductions. That doesn’t mean you can’t or won’t be successful in approaching a VC on your own, but I think there are ways to improve your chance of success.
Here’s my advice to entrepreneurs on what to do and what not to do when approaching a venture capitalist cold.
Do… Research the VC, his/her firm and their investments. If you’re asking a venture capitalist to take the time to read your business plan or take have a call with you, then you owe it to him to take the time to understand who he is and what kinds of investments his firm makes. It’s a waste of everyone’s time if you cold call a VC for funding for, say, an artificial heart valve startup when that venture firm’s web site makes it clear they only invest in software companies. By researching investments that the venture firm has made that are relevant to your opportunity (and by mentioning that research when appropriate), you show the VC that you’re serious, thoughtful and have done your homework. Successful fundraising usually isn’t a game of large numbers (i.e. the number of VCs you send your executive summary to); it’s about being smart about who you reach out to, understanding and articulating why you’re reaching out to them in particular, and having the appropriate follow through.
Do… Reach out to the VC in a way that makes it easy for a VC to respond to your approach. Out of the three primary options—USPS mail, phone and email—I think email is by far the best way to make the initial approach. VCs are notorious for their hectic travel schedules, packed calendars and odd working hours. The cold email approach saves you time and makes it easy for the VC to quickly assess whether your opportunity is one that merits pursuing. Regardless of how you decide to approach VCs, make sure they provide all of your contact info (including email and phone number) so they can re-connect with you in whatever way is best for them. Believe it or not, I have actually received business plans (via USPS) where the only contact information provided was a postal address. I can tell you firsthand that the more options you give a VC for reaching back to you, the more likely you are to actually hear back from him.
Do… Be specific in your approach about why you’re approaching that VC and what you’d like to accomplish. I think it sets the interaction off on the wrong foot when I get an email or a phone call from someone and I have to prompt them during the dialogue to get to the heart of why they reached out to me. Conversely, I really respect it when someone cuts straight to the chase and tells me what they’re looking for and why they think I’m the right person for them to reach out to. It not only tells me the entrepreneur knows what he wants and is confident enough to just ask for it, but it also gives me a sense of where that entrepreneur is coming from, whether he’s done his homework and whether his interpretation of the situation matches my interpretation.
Do… Provide the VC with enough information during the initial approach to allow him to qualify that you and your opportunity are interesting. While “dark and mysterious” may work in the dating world, being coy or secretive in the initial approach to a VC usually backfires on the entrepreneur. I’ve been on the receiving end of emails and voicemails that say nothing more than “I have a really exciting idea for a company and would like to arrange a meeting with you at your office next Tuesday.” While I think most VCs like to be accessible and will generally try to return all credible messages they receive, in most cases an attempt on the entrepreneur’s part to create a sense of intrigue will backfire and cost him or her credibility. If you do leave a message or send an email, give the VC enough information for him to determine whether it’s of interest to him.
Do… Recognize that successful fundraising is usually a series of small steps rather than one large step. Most entrepreneurs wouldn’t expect a venture capitalist to read a business plan and immediately write a check to the entrepreneur. Similarly, it’s unlikely to expect that you can pick up the phone, cold call a VC and immediately have that VC spend a couple hours on the phone going through your entire presentation. Nor should you expect that you can cold email a VC and get him to have lunch with you without his having pre-qualified that your opportunity is interesting. Your primary goal when you first cold approach a VC is simply to determine whether he has any interest in your opportunity. That’s your only ask during the initial approach: “Does this sound like something that might be of interest to you or one of your partners?” And all you have to do is provide just enough information for the VC to be able to respond. Assuming there’s an expression of interest, you can proceed with the dance called fundraising.
Do… Follow through when you make your outreach and be gently persistent. I’m amazed at the number of letters and emails I get in which the entrepreneur concludes by saying “I’ll call you next week to follow up and see if you have any questions” and where I never actually get that call. If I get a credible email or letter, I generally will close the loop regardless of whether the entrepreneur calls me, but if the initial contact promises follow through, then not doing so costs the entrepreneur credibility. Likewise, I don’t think most VCs consciously try to test entrepreneurs’ persistence, but our travel schedules, busy calendars, and existing portfolio demands sometimes create a backlog. Gentle persistence in following up can be what keeps you at the top of their minds.
Don’t… Try to make idle chitchat as a prelude to your “ask”. We’ve all had those telesales calls where an anonymous sales person tries to engage you in pleasantries about the weather, how your weekend was, or whether you think <insert sports team here> can make it all the way to the Super Bowl, etc. I don’t know of many people that enjoy it. If you don’t already have some sort of a personal connection to the VC you’re calling, the first cold call isn’t the time or place to try to force that connection. If you assume that you will only get a finite amount of time from a VC in your initial approach (it’s a safe assumption), spend that time wisely on making your case why your opportunity is a great fit for that VC, not on trying to make witty banter.
Don’t… Name drop, try to create a false sense of urgency, or raise a lot of hype unless you can back it up. Venture capitalists exchange emails, have phone calls, and meet with lots and lots of people. Most can smell wh
en you’re trying to bull-shit them, and the only thing this does is make them more wary.
Today’s great post is from Paul Graham and is titled A Fundraising Survival Guide. Paul runs Y Combinator and has been involved in numerous early stage financings since starting Y Combinator several years ago. Worth a long, slow, and detailed read for any entrepreneur raising money for their startup.
Rick Segal has today’s great post up titled From the Trenches: OS Who? In addition to being enlightening, it’s hilarious. He’s also got some hints about where OS/2 is heading.
Updated: Rick provides some clarification on what he was trying to say in his post Ruh Oh – Time for a butt whoppin (mine).
Fred Wilson has another excellent post up titled Venture Fund Economics: When One Deal Returns The Fund. He continues his expose on how VC funds work and builds his thoughts in this post around the statement:
"Every really good venture fund I have been involved in or have witnessed has had one or more investments that paid off so large that one deal single handedly returned the entire fund."
I’ve been a partner in several venture funds and am or have have been an investor (LP) in around 25 VC funds since 1995. I reach the same conclusion as Fred on slightly different data – every successful venture fund that I’ve been a part of in any way has had at least one deal that effectively returned the fund (I’m changing the assertion a little as I’m including the funds where there were several deals that each returned at least 75% of the fund.)
In 100% of the cases where there wasn’t at least a deal that returned 75% of the fund, the fund was a loser. I can’t think of case that I’ve been involved in or seen the data from a situation where this hasn’t been true (I’m sure this is at least one case, but my assertion would be that it’s an outlier.)
Fred explains it well, but the meta-message is that you have to have at least one home run in a venture fund (where home run is defined as returning at least 75% of the fund) to have a successful fund. For tech VC funds, this is relatively easy to get your mind around for funds under about $300m. Once you start getting into higher numbers (say – $1 billion funds), you quickly realize that to return $750m on one deal, you have to own 20% of a company with a value over $4 billion at the time you exit. That doesn’t happen very often.
Fred’s conclusion is also right on the money as it’s not about just stepping up to the plate and swinging for the fence.
Some will read this and suggest that our business is all about swinging for the fences. But I don’t think so. There are hitters in baseball, the best hitters in fact, that hit balls out of the park when they are just trying to make good contact. That’s how you have to do it in the venture business. You try to make 20 great investments and you work with them closely in hopes that four years in you have six or seven that have home run potential, and after ten years, you maybe hit one or two out of the park. If you try to hit every one out of the park day one, you’ll strike out way too much and the fund won’t work out very well.
Fred is doing a superb job with this series. If you aren’t already a subscriber to his blog, what are you waiting for?
Today’s great post if by Fred Wilson titled titled Venture Fund Economics.
"When I write about venture fund returns, there are always comments and questions that lead me to believe that the economics of a venture fund are not well understood. And since most of the readers and commenters on this blog are people who work in the startup ecosystem, I think its important that the economics are better understood. So I am planning on some posts on this topic in the coming weeks."
This appears to be the first of several posts Fred’s planning to write on this topic. I’ll try to remember to point them out when they appear.
Q: When we talk about the equity percentage numbers for those directors and other early participants, are these numbers based on the total number of shares prior to a funding event or does the base share number include those allocated for investors as well? As the shares for future investors are hard to predict, I assumed that the percentage numbers we talk about here are before any dilutions, is that right?
A: (Brad) The answer is "it depends." When we have written about equity and compensation in previous posts, we’ve tried to provide some context for the stage of the company. When we’ve done this, you should assume that this does not include future dilution from other rounds of investment.
However, there are no absolute guidelines. For example, when you bring on an outside board director, whether it is at the Series A or the Series D, the stock option grant is usually in the 0.25% to 1.0% range. While this is a wide range (see – there are no real rules) it gets more complex when a director has been with the company for a while and taken dilution from subsequent financings. For example, assume a director joins at the Series A and gets a grant for 1% vesting over four years. Three years later, the company has raised $30m and the directors grant now represents 0.3% of the company. In some cases, the director would get an additional option grant to increase his ownership percentage (say – back up to 0.5%); in others he wouldn’t. This is a function of the board, the investors, the entrepreneurs – all based on their view and assessment of the director’s contribution.
The same is true for employees. Most employees will take the same dilution the founders take with subsequent financings. This is relatively easy to deal with in the success case because the dilution is less significant and the value of the equity continues to increase. However, in cases where the dilution is significant (e.g. a down round financing) employees need an "option refresh" – this is usually negotiated in the context of one of the financings. In addition, as employees start to reach the point where their equity is fully vested (as they’ve been at the company for four or five years) there is often a refresh option grant.
There’s no simple answer. And – any numbers we put on this blog are merely guidelines. You mileage will vary dramatically with the situation.