Burnham's Beat

2008 Software IPOs: Year in Review

While the Software sector did not fare as poorly as the Internet sector when it comes to IPOs in 2008, it did not do much better.  In fact it did just 1 better; as in 1 IPO for all of 2008. This is obviously the smallest # of Software IPOs since we began compiling a list of them 5 years ago.

Who was the lucky winner?  It was a security software company called ArcSight (ARST).  ArcSight managed to get public on Valentines Day, 2/14/2008, at a price of $9.00/share.  Things were looking grim for ARST in mid November with the stock trading close to $4/share, but they fortuitously reported a "beat and raise" quarter in early December and the stock rallied furiously.  So much so that Arcsight closed the year at $8.01, off only 11% from its IPO price.

Other than Arcsight, the Software IPO space was a quiet as a country mouse and based on the paucity of recent S1 registrations it will be awhile before there are any more Software IPOs to speak of.

2008 Internet IPOs: Year in Review

This is going to be an easy review.  That's because 2008 will likely go down as the first year in the modern "web" era of the Internet that there wasn't a single Internet related IPO in the major US stock markets.  That's right, not a single one, zippo, nada.  There were a few spin-offs and a couple cross listings but as for brand new spanking public Internet companies there wasn't a single one.  It's enough to make a make a grown VC cry.

As it stands, the last IPO of an Internet focused company was arguably NetSuite, which went public on 12/20/08 at a price of $26/share and closed today at $8.44.  And that 68% price decline, ladies and gentlemen, is all you need to know on why there hasn't been an Internet IPO since then.

That makes it 377 days without an Internet IPO.  I modestly suggest that Sand Hill VCs should tie a ribbon made of $100 bills around a Redwood tree outside their offices until such time that the market stops holding their late stage deals hostage.

Granted there were only 30 IPOs in the entire market in 2008, but you'd think that what is supposedly one of the fastest growing, highest technology sectors in our economy would be able to contribute at least one good IPO.  Oh well, maybe next year.

Who Will Be The Biggest Loser: 1999 VC Funds or 2006 PE Funds?

1999 vintage Venture Capital funds are infamous for being some of the worst performing private investment funds of recent memory with the average 1999 Venture Capital fund returning only about $0.95 on the dollar through 6/30/08.  The poor returns of these 1999 funds are a result of two main factors:

1. These funds were raised at or near the height of the tech bubble.
2. These funds were often fully invested within 12 months of closing.

The result was a ton of money invested very quickly at very high valuations.

During the 3 year market correction that followed the tech bubble, venture capital lost favor with many institutional investors.  Many of these same investors instead plowed their investment dollars into private equity funds.  These funds enjoyed huge returns early in the decade as an extremely loose credit market combined with very low risk premiums and declining loan underwriting standards gave rise to such as wonders as dividend recaps, PIK toggles, and covenant light loans.  By late 2006, private equity firms were raising absolutely gigantic funds with terms and fees that would make many VCs blush.  Part of the private equity pitch at the time was that because they were buying well established firms with ample cash flows and "fundamental value", private equity would never see the same kind of market collapse that cratered 1999 and 2000 vintage VC funds.  LPs generally lapped up the pitch and as a result during 2006 and early 2007 there was a ton of money raised and invested very quickly at relatively high valuations.  Sound familar?

Fast forward to today's market and the "fundamental value" of many private equity funds appears highly suspect thanks to two main developments:

1. The credit markets have completely imploded effectively making it impossible for private equity firms to refinance existing debt.
2. The recession is impacting earnings and cash flow which in turn is increasing the likelihood of loan defaults.

Against this backdrop, the massive leverage that enabled private equity firms to put up such huge numbers in the 2002-2005 time frame now looks like it has the potential to absolutely decimate 2006-2007 returns.

But don't take my word for it, just look at the market.  Unlike VC investments for which no reliable daily market values exist, most private equity deals issue publicly traded debt and that debt provides an immediate window into the health of the deals themselves.  Just how healthy are those deals?  Not very healthy at all.

Even after today's big rally, the kind of senior bank loans often issued against private equity deals are trading at or near all time lows with some of the highest profile private equity deals trading at discounts of 25-30% from par.  What's more, many closed end mutual funds that specialize in such loans are themselves trading at 20-30% discounts to their Net Asset Values which strongly suggests that senior loans have even further to fall.  Clearly the market is anticipating some major defaults in private equity land in the near future.

Defaults are bad news for PE funds because they are generally catastrophic for the equity holders in a deal and the equity holders in these deals are, you guessed it, the 2006-7 private funds.  Thus, if the market is to be believed, a lot of private equity funds are going to see catastrophic losses on their equity investments in the next couple years.

Private equity LPs, like many homeowners these days, are about to learn a lesson in the downside of leverage.  They may end up wishing they put all their money into 1999 VC funds instead.  Imagine that!

4 Things to Do After You Get Your First Term Sheet

I’ve recently been involved in helping a couple companies with their first major round of VC financing.  It’s actually been pretty interesting for me because I have histroically been on the other side of the table.  In addition to generating several stories worthy of “The Funded” and getting a better appreciation of the trials and tribulations that entrepreneurs must go through when trying to raise money, I also gained a better appreciation for just how important it is to properly manage the “end game” of a VC financing.

What is the “end game”?  The End Game generally takes place after you have gotten a term sheet, but before you actually sign it.  How well you manage this process can make a big difference in the actual terms and pricing you ultimately get, so it pays to approach this process as thoughtfully and diligently as you do any other part of fundraising.

With that in mind I present 4 things that you should definitely do after getting your 1^st term sheet:

1. Get a second term sheet:  It may sound flip, but this is the single most important thing you should do upon getting your 1^st term sheet.  Nothing loosens up a VC’s purse strings or makes them more flexible on a particular term than the threat of competition.  Without competition (real or perceived) you have very little leverage against a VC.   Now getting one term sheet, let alone two, is tough enough, but getting two must be your goal and you must not waiver in pursuit of that goal even you after you get the 1^st one.  The biggest problem most entrepreneurs have executing on this strategy is that they have mismanaged the sequencing of their fundraising.  Many entrepreneurs make the mistake of pursuing an “in order” fundraising process whereby they take one meeting, run that process to its logical conclusion and if that doesn’t work out try to get a meeting with another VC.  VC fundraising must be pursued concurrently!  You must put as many irons in the fire in as short a time as possible so that all the firms start the process at roughly the same time. As firms progress through the process, you should do your best to try and “herd” them along by trying to slow down the ones pushing ahead and speed up the ones lagging behind.  The ultimate goal is to ensure that when you receive your first term sheet you have several other firms that are very close (within a week or so) to potentially issuing their own term sheets.  Proper sequencing ensures that you are not forced to take an inferior “bird in hand”.
2. Ignore term sheet “expiration dates”:  Most VCs put “expiration dates” in their term sheets (usually at the end).  In almost all cases these are artifices that are inserted into the term sheet in order to put pressure on the entrepreneur and to try and prevent them from “shopping the sheet”.  The reality is that as long as you are negotiating in good faith with a VC they are not going to pull a term sheet.  That’s not to say that VCs won’t pull a term sheet if they feel like you are being dishonest with them or have no real interest in taking their money, they will, but as long as you deal with them professionally and explain to them why you need more time to consider their offer, they will extend their phantom “deadline”.
3. Do some due diligence of your own:  One of the more unfair aspects of VC fundraising process is that VCs are allowed to take months probing every orifice of your company, but entrepreneurs are expected to make one of the most important decisions of their life in a week or two and often with little or no information.  There’s no good reason for this and all entrepreneurs would be well served by taking some time to do some basic due diligence on any investor who has offered them a term sheet.  I suggest, at a minimum, talking to at least two entrepreneurs that the VC has funded and then talking through with the VC A) all the deals they have done and what happened to them B) the current status of their fund and partnership.  Doing your own due diligence has 4 main benefits 1) it may help you avoid making a bad decision  2) it will create the perception of a competitive process 3)  it will make you appear more savvy and diligent to the VC  4) it can come in handy when you are trying to stall while you get your second term sheet.  Don’t go overboard and act like a VC by asking lots of annoying questions and drilling to the center of the earth on irrelevant/tangential questions; just ask for a few reasonable pieces of information and be very gracious about it.
4. Negotiate:  By the end of the fundraising process most entrepreneurs are so fatigued and shell shocked that when they finally get a term sheet they are loath to do anything that might upset the apple cart.  This situation generally leads to some pretty one sided “negotiating” sessions in which the entrepreneur meekly asks to eliminate the triple participating preferred, the VC says “NO!”, and the entrepreneur quickly retreats.   The reality is that VCs expect some negotiating and their first offer is never their best.  That means you should, within reason, feel free to push back on their initial offer.  Of course, if you have a second or even a third term sheet you can push back even harder, but even if you only have one term sheet you should still push back.  As they say, it never hurts to shake the tree.

If you follow these four pieces of advice you will put yourself in position to get the best possible outcome.  The most important thing to remember is that once you get a term sheet, the whole dynamic of the fundraising process changes and the ball is now in your court.  How you “return serve” can make a big difference in the outcome as I've seen VCs increase their initial offers anywhere from 25–50% when these principals are applied.  Your mileage may very, but its definitely worth a shot.

 

Microsoft/Yahoo: A Bad Deal For Silicon Valley: Take II

Marc Andreessen has posted a very thoughtful rebuttal to my argument (as well as Fred's and few others) that the Microsoft/Yahoo deal is a potentially a bad thing for Silicon Valley.  The funny thing is that I actually hadn't noticed the post yet in my feeds but it was brought to my attention by a number of people who were basically like "Oooo, you've been served!" and were wondering if I was going to challenge Marc to some kind of blog-off or something.

I hate to disappoint folks, but after reading Marc's post I actually agree with most of what he has to say, especially his overarching message to start-ups, which I took to be "Focus on building a great business and the exit will take of itself".  Marc also made a number of other good points around the M&A environment which if I could sum it up were basically "Hey, life will go on, other companies will try to take up the slack, it's not the end of the world."  In particular I think his point that a combined Microsoft/Yahoo may prompt some second tier firms to increase their M&A is a good one.  I also agree that over the long term, creating a big bureaucratic behemoth such as Microsoft/Yahoo is a good thing for start-ups because it means that start-ups will likely be able to dash ahead of the lumbering giant and secure fresh new areas of opportunity well before the folks at Microhoo file even their TPS reports and get out of their staff meetings.

That said, I still think that Microsoft's acquisition of Yahoo is still a net negative from an M&A perspective.  Yes, it's certainly not the end of the world, but on the whole and on the average it's never a positive thing to have an active, well endowed, acquirer removed from the mix.  Yahoo may not have been buying 50 start-ups a year, but they were still one of the most active Internet acquirers not just in terms of deals, but also in terms of bids.  Indeed the most important party in any deal is not the actual buyer but the second place bidder and Yahoo had seemed to make a career out of being the second place bidder lately.   Finally, thanks to its huge market capital, massive traffic and strong (although not relative to Google) monetization platform, Yahoo is one of the few Internet acquirers who have the luxury of being able to easily drop $50-$100M on a "feature" without really thinking about it.  I totally agree with Mark that if you are building a "feature" with the intent of getting acquired by Yahoo or whoever, you were likely doomed to failure a long time ago, but at same time, the cynic in me has seen a lot of "features" get funded in the valley over the past two years often under the assumption that if they get enough eyeballs one of the big three M&A fairies will swoop in and drop $100M just to "keep up with the Joneses".

So I agree that life will go on in the valley and there are some real positive non-M&A aspects of the deal for start-ups, but at the same time, I think net, net it's bad for the M&A environment.  That may change over time as new companies emerge to take up the slack, but over the next 24 months things could be a bit rough because not only will you have Microsoft and Yahoo thoroughly distracted,  but IAC is going to be a complete mess due its dispute with Liberty and AOL appears consumed with consummating its death spiral within Time Warner.  I am sure M&A bankers will do their best keep the deals flowing, but if you have an Internet start-up, given the turmoil within the big acquirers and the rapidly deteriorating economic environment, as Marc suggests, you should definitely just keep you head down on focus on building a real business.

Microsoft/Yahoo: A Bad Deal For Silicon Valley

There's a ton of discussion today about Microsoft's unsolicited bid for Yahoo.  Much of the discussion focuses on whether or not the deal is a good thing for Microsoft, Yahoo or Google's shareholders.  While it's possible it could be a good or bad deal for one, the other, or all three, one thing is for sure:  this a bad deal for Silicon Valley start-ups and their VCs.

How could that be?  Because by swallowing up Yahoo, Microsoft will be removing one of the biggest and most active acquirors of start-ups in Silicon Valley.  The intense competition between Microsoft, Google, and Yahoo has arguably been one of the main factors helping drive up M&A activity and prices for internet related start-ups.   It seems like every rumored acquisition over the past few years has had all three fighting in some way to win the deal.

Even though Yahoo has been wounded of late, it still had a market cap in the 10's of billions of dollars which allowed it to be a legitimate competitor for any deal under $1BN and in fact Yahoo has been a pretty active player in that market whether its del.icio.us, flickr, Rivals, etc.

If it's acquired by Microsoft, that will leave only two Internet media/search acquirors with the ability to easily do sub $1BN deals.  What's more, while Microsoft has recently show a willingness to deal really big deals such as Acquantive and now Yahoo, it has traditionally been less willing to smaller "tuck in" deals, deals that Yahoo has traditionally been much more active in.  Indeed, Microsoft has traditionally been dismissive of these deals because they just don't move the needle for them and their engineering staffs still retain a relatively high degree of NIH attitude.

Losing one of the Valley's most reliable "tuck in" acquirors and second place bidders is a net negative for the Valley.  It will make M&A less competitive in general and will reduce the # of potential exits for "me too" start ups" to 2 instead of three.  That's bad news for Internet content/search start-ups and their VC backers anyway you look at it.

Stratify: A Post-Bubble Success Story

So Iron Mountain, the world’s biggest record management company, announced today that they are going to acquire Stratify, the leader in legal eDiscovery,  for $158M in cash. Stratify just happens to be the first early stage investment I ever made and I thought I would write a bit about the deal because I think it’s an interesting story of a “bubble” company that went through some very tough post-bubble times but ultimately achieved success thanks largely to the perseverance and flexibility of a great team. This is a long post but I think VCs, entrepreneurs and investors will find many of the details interesting.  Before I get into that though I just want to congratulate all the people at Stratify, especially George, Meena , Joy, Sanjeev, Hakan, and Ramana.  You guys hung in there in the face of a lot of adversity and you deserve all your success. 

A Bubblicious Beginning…
I made the original investment in Stratify back in September of 2000, although it wasn’t called Stratify then it was called Purple Yogi and it wasn’t focused on legal eDiscovery back then either , it was focused on a “widget” that automatically categorized news and information in a way that enabled consumers to discover related information easily.   Underneath the widget was an incredible unstructured data management platform built by a team of technology “rock stars”.  While Purple Yogi had undeniably amazing technology (man was it cool!), its business model was a little less impressive in that it really didn’t have one, which kind of explained why it didn’t have any revenues at the time either.  I am embarrassed to say it now, but I invested what was clearly a crazy “bubble” era valuation in their first round of VC funding. That said, 2.5 months after we put that money in, the company raised another round of capital from a new lead investor at an up-round valuation and I was looking at a nice mark up on my first early stage deal in less than 3 months.  I had gone from crazy to genius in 3 months!

Reality Sucks
Reality soon set in though.  As the consumer advertising market collapsed in the wake of the bubble bursting it was clear that Purple Yogi wasn’t going to be making any money selling advertising alongside its widgets, so we decided to focus the business on building an enterprise version of the technology.  This had been part of the plan all along, but it now became the sole focus of the company.  In conjunction with the new focus, we brought in a very accomplished enterprise-focused CEO, made a lot of painful staff reductions, and changed the name to a more corporate sounding “Stratify”.

The newly christened Stratify focused on building a world class unstructured data management platform and thanks to its fantastic tech team it quickly had an awesome product.  For the next two years Stratify tried its hardest to make this business work and it actually had a good deal of success selling to some of the most sophisticated buyers of information management software in the world.  The only problem was that every sale was like fighting trench warfare because Stratify was selling a very “heavy” traditional enterprise software product that not only required customers to write a very large up front software license check, but also required them to make significant investments in ancillary software and support services.   What’s more, because Stratify’s software was so sophisticated and so high-end the addressable universe of potential customers that could A) understand the value it brought and B) had a big enough problem to justify buying it was actually pretty small. The reality was that they had a fantastic product in what was effectively a very small market.  Everyone put their heads together to try and figure out how to build the business faster, but in many ways the company was stuck.  And then something totally unexpected and very fortuitous happened:  I got sued.

Thanks for Suing Me!
In late 2002 I got sued because I was on the board of another company that was embroiled in a legal dispute with its founder who decided to sue the board and company.  As anyone who has had the pleasure of getting sued knows, one of the first things that people do after getting sued is that they collect all the information, typically mostly e-mails, surrounding the issue(s) in question and review them to try and see what the facts of the matter are.  Shortly thereafter you are usually required to give most of these e-mails to the person suing you in a process that lawyers call “discovery”.   As I tried to sift through the morass of e-mails related to this case, I immediately thought of Stratify and asked the CTO if it might be possible to use Stratify’s system to review the e-mails.  The CTO told me that it was in fact possible and that the crack tech team had actually been working on some skunk projects that could be adapted to this purpose.  They quickly cobbled together a makeshift solution and after some initial tests we were all uniformly amazed at how well the system performed and how much easier it was to review e-mails when Stratify’s technology had been used to filter and classify them first.  I was even more amazed when I asked some lawyer friends and they told me that large law firms can easily pay $500K to review e-mails for a single large case.  That sounded like a very promising market.

As it happens, at the same time that we were just starting to think about legal discovery as a potential market for Stratify’s technology, a large software company, who had been flirting with the company for awhile, made a surprise offer to acquire the company as they sensed that due to investor frustration with the slow growth of the enterprise business they might be able to acquire the deal on the cheap.   While I personally thought that there couldn’t be a worse time to sell, practically every other investor wanted to take the deal. They were fatigued and generally freaked out by the market, which at that point in early 2003 was just about reaching rock bottom after almost 3 years of declines.  We settled on a compromise where we took the existing cash in the business and bought out everyone that wanted to sell, which turned out to be almost everyone but us.  After closing that transaction, I set out to try and raise another small round of funding from other VCs and despite a few months of trying I didn’t get a single taker, despite the fact that the legal eDiscovery business had quickly moved from product concept to making a few large sales in less than 6 months.  Nobody was in the mood to take a risk back then.

A Perfect Match
As it turned out though, the legal discovery business not only began to pick up steam, it was quickly becoming clear that the opportunity was even larger and more attractive than we had hoped.   It was like night and day from the enterprise software business.  Instead of 9 to 12 month sales cycles we now had 2 to 4 week sales cycles.  Instead of having to get internal IT to sign off on a laundry list of integration and implementation issues, we sold the product as a fully hosted SaaS solution that was up and running in a matter of days.  Instead of making one big sale per customer, we could make numerous small sales, often to the same partner at a law firm.   Finally, instead of having a very small set of potential large enterprise customers, we now had every law firm in the world and any person or company that had been sued or was suing someone as a potential customer.  Business was so good that Stratify stopped trying to raise the extra capital from VCs and in fact never raised another dollar of equity financing.

I had to resign my board seat at Stratify when I left Mobius, but for the next few years, with the able assistance of Jason and Chris, the team kept building the eDiscovery business to the point that it was clearly a very successful business.  I stayed in touch with the team and tried to offer encouragement and assistance, but they didn’t need any help; they finally had a market and a business model that took full advantage of their fantastic technology.  With growth and success came multiple suitors and it was inevitable that one of them would offer a deal that made too much sense to pass up and that’s exactly what happened today.

Lessons Learned
I learned a lot of investment lessons from Stratify, the most important of which are:

1. Don’t underestimate the value of a great technology team.   Great tech teams can quickly adapt a product to suit changing markets and priorities.  They also create products and technology with lasting value that can be leveraged in multiple ways.
2. If at first you don’t succeed, find a new market and/or a new business model.   It’s often said that very few start-ups achieve success with their original business plan and after my Stratify experience I believe it.  Start-ups should always keep an open mind about potential changes in business model or market focus that might increase the chances for success and should be honest with themselves when it is clear that they are “stuck”.
3. When everyone else is selling, it’s not a bad time to think about buying.  In the public markets they call it capitulation; in the private markets they call it fatigue.   It’s hard to fight the urge to run with the herd, but if you can, you can often make a lot of money.

Venture investments can be real roller coasters.  Stratify went through two business model changes before they found the market, model and product that clicked .  Through it all a core team of people stuck it out and ultimately built a great business that everyone can be proud of. Congrats again to all involved!

Fortune Magazine Fight Fest: Private Equity vs. VC

Just came back from a lunch for about 50 people that Adam Lashinsky of Fortune Magazine hosted.  The topic de jour was the whole carried interest taxation debate.  Adam moderated a great panel that included Mike Moritz from Sequoia, Dave Roux of Silver Lake and Prof. Darryll Jones, a tax law expert.

The panel had some pretty interesting things to say and also revealed some very stark divisions amongst the various players in the carried interest drama.  A few quick take aways:

1. Surprisingly, it seemed like the biggest debate took place not between the investors and the Professor, who was outright opposed to any capital gains break for carried interest, but between Roux, a private equity guy, and Mortiz, the VC.  Mortiz took great pains to distance Venture Capital from private equity while Roux tried to argue that the two basically did the same thing, albeit for different stage companies.
   
2. Between Mortiz's comments and those from Ted Schlein (the current head of the NVCA, who was sitting at one of the tables) it's crystal clear that A) the NVCA believes some kind of legislation on this issue is going to pass (probably by December) and B) they are moving as hard and fast as they can to try and cut their own deal with Congress that exempts Venture Capital from some or all of the tax increases (while presumably still sticking it to Stephen  Schwarzmam & Co.) Personally I think the "every man for himself" strategy being followed by the NVCA is a mistake.  Political fights are won by horse trading enough to build as big and broad a coalition as possible and as such the NVCA should be trying to pull more groups into the fight (especially small business owners), not selling everyone else out in the hopes that some kind of high minded argument about the "public good" of venture capital vs. other kinds of investment capital wins the day.  The politicians are looking for money and votes and the only way to win that fight is to fight fire with fire.  That said, it will be very interesting to see if the NVCA's gambit pays off and one has to imagine that the NVCA wouldn't be pursuing this strategy if they didn't have a bunch of votes already lined up for it.  My guess is that it won't work and all the NVCA will have to show for it is a lot of pissed off Private Equity guys, but I also hope that I am wrong!  Kind of ironic given that the lines between the two industries seem to blur daily, but for now the battle lines are clearly drawn.
3. The curent wild card in the debate appears to be that the Joint Tax Committee has yet to report on how much money they expect the proposed changes to carried interest will add to the treasury.  Prof. Jones said one early estimate out of the University of Pennsylvania was that the changes would only add $2-$3BN in tax revenue/year and that was before any strategies were devised for avoiding the new taxes.  This is important because many Congressmen are apparently hoping that this change will offset most if not all of the $50BN in taxes lost to a likely AMT tax repeal.  However if changing the carried interest provisions only generates a few billion in revenues, the political calculus is likely to get a lot tougher for Congressmen because they will risk alienating a decent number of their best campaign contributors to generate what, from the government's perspective, is a tiny piece of revenue that doesn't even come close to solving their main political problem.  Thus it would appear to me that in the near term the single most important thing to watch out for in this debate is just how much cash the committee estimates the proposed tax changes will generate.
4. I continue to be struck by the fact that the "pro-tax" side of this debate, is basically taking a position which denigrates Labor at the expense of Capital. Prof. Jones was actually the first person I've seen on this side to express some reservations on this point, but besides him almost everyone else on that side of debate seems to be oblivious of the tremendous irony and contradictions inherent in their position.  As is often the case in politics, principles are no match for money.
5. One other interesting thing to note:  I asked the Prof. if a VC should have to pay ordinary income tax on carried interest even if they received no salary or cash compensation at all, and he said "yes" because the carry was still compensation for labor, even if it was delayed and at risk.  Then I asked if that same reasoning applied to entrepreneurs, i.e., should entrepreneurs that invest time/effort/IP have to pay ordinary income on the profits from sales of their stock and he once again said "yes" because, just like VC's, this was compensation for services provided, not capital.   I give the Professor a lot of credit for being logically consistent, because it seems crystal clear to me that those who advocate eliminating capital gains for carried interest are logically compelled to have the same position when it comes to other forms of sweat/intangible equity, but I think the Professor is one of the few people on that side of the debate that have the courage to be upfront with the logical consequences of their position.  Based on this, it's clear to me more than ever, that the carried interest debate is just a prelude to eliminating the concept of sweat equity/intangible capital from the tax code altogether.  This means that entrepreneurs laughing at the sight of "rich" VCs trying to maintain their cushy tax breaks had better stop laughing because you guys are clearly next on the hit list.  Don't believe me, just do the math:  would the government generate more revenue by taxing all the profits generated by all the people who get sweat equity stock or all the 20% of the profits generated by VCs who get carried interest?  Before you answer this consider that if you changed the tax treatment for "founding stock" to ordinary income than the Google Founders alone would generate at least another $4BN in incremental taxes on their $20BN+ stake.  Doesn't take Einstein to figure out what's the quicker way to fill a $50BN hole.

Sequoia vs. Yale

There's an excellent story in the Wall Street Journal today about some venture funds "taxing" their limited partners (LPs) by either explicitly or implicitly requiring their LPs to commit to other non-core funds in order to get an allocation in their main fund.  This really wasn't an issue until recently because in the past most VC funds only had one "main fund", but in the last few years many of the top-tier VCs have been aggressively raising separate funds focused on either late stage/growth capital or specific geographies, such as China and/or India.

The juiciest part of the story is a spat between Yale and Sequoia in which Sequoia allegedly kicked Yale out of it's main fund (easily one of the toughest top-tier funds to get an allocation in) because they wouldn't play ball and invest in Sequoia's rapidly increasing stable of stage and geography specific funds.  While I suspect most of the folks at both Sequoia and Yale are probably displeased that their dispute made it into the Wall Street Journal, they shouldn't be because the article cements both firms as the current "big dogs" in their respective industries:

• Sequoia should be pleased because there could be no stronger signal to the LP community that they are the top dog in the VC world then kicking out Yale, one of the the most sought after LPs in the venture community.  As they say, the best way to stop desertions is to conduct a few public executions and you can't get any more public than the Wall Street Journal.  My guess is the next time Sequoia calls it's LPs asking for money, for any fund, the only question they are going to get is "How much money am I allowed to give you, sir?"


• Yale should be pleased because this officially cements them, and David Swensen in particular, as the LP with the biggest cojones in the industry.  Most LPs would kill to have access to Sequoia's funds and yet Yale is willing to walk on principle.  Yale can walk because they have one of the best investment track records and are an acknowledged trend setter in the LP community.  Walking from Sequoia makes them a man among man.

It will be interesting to see if Yale's principled position turns out to be the right call in the long term.

Understanding Why Your VC Is Acting Crazy

One thing that many entrepreneurs don't fully appreciate is just how much the financial and organizational dynamics within a VC fund can affect how a VC behaves on their board. Over the years I have heard many stories from entrepreneurs expressing various degrees of frustration and mystification over a position taken by their VCs, usually with regards to an upcoming financing or an M&A transaction.  For example, in some cases a VC that has been very supportive about patiently growing a business all of a sudden becomes obsessed with selling the company or in others a VC that has been aggressively pushing the company to grow quickly all of sudden becomes extremely cost focused and lobbies hard to cut the burn rate despite the fact that this will kill growth.   After witnessing such abrupt changes in attitude and direction, many entrepreneurs are left scratching their heads wondering "What the hell is going on with my VC and why are they acting so crazy?"

The answer to this question can often be found by simply getting a better understanding of the current financial and organizational dynamics within a VC's fund, as these issues can have a profound impact on how a VC and/or their fund approaches a specific investment.  With that in mind, here is some specific advice for entrepreneurs in terms of what questions they should be asking VCs and what information they should be monitoring.

Financial:   There are several key pieces of financial information about a VC fund that you should do your best to determine before taking VC money and should regularly monitor once you have taken money.  These include:

1. Fund Size: First, you should know how big the specific fund that is investing you is and you should calculate what % of that fund is likely to be invested in your business.  The bigger the % of the fund invested in your business, the more important the investment is not just to the individual partner on your board, but to all the partners in the fund.  Being a large piece of a VC's fund can often be a double edged sword .  While it usually makes it easier to raise follow on financing, it also makes the VC more downside focused and very sensitive to any deceleration in business momentum.  Conversely, if your company accounts for a very small percent of the fund, don’t be surprised if you don’t get a lot of love and attention from the fund and be forewarned that the fund will be much more willing to shut down the company or sell it off at a loss if you hit a big rough patch as the financial impact of such a loss will be limited and the effort required to “save” the investment would be better spent on the “bigger bets”.  This logic plays out not just at the fund level, but often at the partner portfolio level.
2. % of Fund Called:  When a VC says they have a $500M fund, that doesn’t mean they have $500M sitting in the bank, it means they have $500M in contractual commitments and that they can “call” on these commitments whenever they find a worthwhile investment.  As a general rule, you are better off taking an investment early on in a fund’s life ( <20% called) than you are taking when its 75% called.  That’s because there is plenty of money available for both new and follow-on investments when a fund is 20% called and also plenty of time available for those investments to perform before VC’s will find themselves groveling in front of LPs trying to raise another fund.  Typically when a VC fund has called about 75% of their fund, they start fundraising for their next fund.  Like mating season, VCs in the midst of fundraising season tend to behave a little strange and have a heightened sensitivity to any M&A overtures that would result in any kind of positive exit for them.  Thus, don’t be surprised if your VC all of a sudden seems very interested in exploring that half-baked offer from your crappy competitor.  You should also not be surprised if the same VC that threw around money like a drunken sailor when they were 15% called, transforms in Scrooge when they are 90% called as the last 10% of the fund will typically be subject to a Darwinian struggle within their firm.
3. Fund Performance:  You should try to keep track of how the specific fund that invested in your company is performing.  In general, if that fund is knocking the lights out, the fund will tend to be much looser with the cash and your specific VC will be much more pleasant to interact with.  However, you should be aware that in funds doing extremely well, it’s even easier for VCs to abandon small under performing investments because it won’t hurt their pocketbooks that much and they have an incentive to do a little “spring cleaning” as it will enable them to help justify raising a new fund.  Conversely if their fund is doing poorly, expect the VCs to be much more dilution sensitive when raising incremental money and expect them to much more ready to sell out for even a modest profit, especially when/if  they are preparing to fundraise.

Most of this financial data is not publicly available, so the only way you are going to get it is to ask the VC partner you are dealing with or cozy up to one of the LPs in the VC fund.

Organization:  As with financial information, you should also keep careful track of some key organizational data within a VC firm including:

1. Pecking Order:  Some VC firms have very clear hierarchy’s while others don’t.  In the case of a clear hierarchy you can just look at the titles on their “About Us” page to see who is likely running the show.  In cases where everyone has the same title, you can generally determine who holds the most influence by determining which partner  has been there the longest and/or which has the most investment success.   Make sure to ask any VC you are taking money from how long they have been with the firm and what deals they have done.  Why does this matter?   Because VCs with tenure and/or strong investment success tend to have an easier time of pushing through both new deals and follow-on fundings, especially when it’s a close call.  Having that kind of pull on your side can make a big difference if your business hits an air pocket and needs to raise an insider round.  Conversely if the partner on your board is new to the fund or has been putting up goose eggs for the last 5 years, they will generally have a harder time getting financings done within the partnership.
2. Size of Portfolio:   The number of deals that an individual VC partner is responsible for will often have a large impact on just how much value and support you get from a VC.  If a VC is already on 10 boards, don’t expect to see them devoting 20 hours a week to helping make your company a success.  For some entrepreneurs this is exactly how they like it, but for most this can be frustrating when you really need a specific introduction or piece of advice.  Size of portfolio can also impact how easy/hard it is to raise money from a VC.  A partner with 10 boards is likely to apply a pretty high screen to doing an incremental deal, while a partner with just 2 boards likely feels pressure from within the partnership to do more deals and thus is likely to have slightly lower standards.  Once they make an investment, a partner with 10+ boards will probably have a tendency to bail more quickly on poorly performing deals than one with just 3 because the one with 10 has to triage their time and can always justify killing off a poorly performing deal if it means that they will have more time to spend at their biggest potential winners.  In general, it’s a good idea to keep track of the other boards your VC partner sits on and how those companies are performing.  Their bad mood at your board meeting may be result of another company’s performance and not your own.
3. Firm Messaging/Focus:  VC firms tend to evolve their market positioning and messaging over time, usually in response to wherever the most money is being made.  Early stage firms start doing late stage deals, technology firms start doing media deals, Austin firms start doing Dallas deals, etc.  You should make sure that your company’s positioning in terms of stage, geography, and sector focus is consistent with where the firm is heading.  When raising money, definitely take this into account as this will prevent you from wasting your time with a firm that really has no intention of investing in you.  After taking an investment, monitoring this will give you a sense of how committed the firm is likely to be to your company and may help explain strange changes in attitude or outlook on the part of the firm and/or your particular partner.

In closing, when trying to figure out just why a VC is acting "crazy", you can’t just think about the problem in terms of your own company (although it may indeed have everything to do with your company), you have to consider the financial and organizational factors that the VC is dealing with within their own firms.  Once you get an understanding of this, you still may not like what your VC is doing but at least you will have a better understanding of why they are doing it.