Burnham's Beat

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.

10 Pragmatic Steps To Raising Venture Capital

As a former VC I am often asked by entrepreneurs “I am having trouble raising money, can you please give me some advice on how to improve my chances?”  Beyond having a start-up that is obviously the next Google, there is no easy way to raise VC money, especially if you are a first time entrepreneur with few, if any, VC contacts.  The harsh reality is that you face an uphill battle to get a meeting, let alone a term sheet, but the good news is that by taking a pragmatic approach to getting your foot in the door you can greatly improve your chances.

All too often I run into entrepreneurs whose fundraising strategy amounts to “I sent a form letter to the 15 VCs I saw mentioned in Tech Crunch yesterday, but none of them got back to me.”  Rather than randomly spamming VCs, you are much better off taking a very pragmatic and methodical approach to fundraising.  This method should force you to identify those VCs that are most likely to not only be interested in your start-up idea, but also to have the cash, capacity and inclination necessary to pursue it.

To that end I offer this 10 step method for getting your foot in the door of a high probability VC.  Once you get in the door, the rest is up to you:

1. Prepare a 10-15 page power point presentation and a 1-2 page executive summary.  That’s it.  Don’t bother with a 100 page business plan, no VC is going to read it.  Make sure the documents cover: stage, location, team, market, market size, business, business model, capital structure, and capital required.
2. Get a list of VC funds.  This list from the NVCA is good place to start.  The NVCA also puts out a member directory that shows which funds are interested in specific sectors, but for some reason they don’t make that accessible, but almost any VC will have a copy.
3. Go through the raw list and identify those VC firms that make investments in your sector, stage, and city.   You can do this by going to each firm’s website and reviewing their high level firm description and noting their location.  As a general rule, it’s pointless pitching an early stage company to a Silicon Valley VC if you are in Alabama.
4. Go through this initial subset of firms and identify specific partners at each firm that focuses on making investments in your specific sector and stage of development.  You can do this by going to the websites at venture firms and reviewing the portfolio’s of the individual partners.  Don’t send your software company pitch to the partner with 10 semi-conductor deals, it’s a waste of time.
5. After you identify a list of specific partners at specific firms investing in your specific stage and sector, then try to indentify how many boards each of those partners are currently on.  You can usually do this by just reading their bio or just looking at the firm’s portfolio company list. Sort the list by fewest board seats first.
6. Try to identify when each partner’s VC company raised its last fund.  You can usually figure this out by looking at the firm’s press releases.  The more recent a new fund has been raised the better.
7. Priority rank the partner list with the goal of having the partners with the strongest sector focus, the least number of board seats at the firms with the newest funds at the top.  It also helps to rank this list by age, because younger partners are less likely to have significant “recycled” deal flow and therefore more open to newcomers.
8. Figure out if you know someone who knows that partner.  For example, go to LinkedIn and try to figure out if you know someone within 1 or 2 degrees that knows the partner.  If you do and you are pretty sure you can get a warm intro, call in that favor ASAP.
9. If you strike out on a warm intro, do a Google Search and try to figure out if the partner A) has a blog or B) has recently said something mildly intelligent in some other public forum.  Then send that partner a personalized e-mail indicating deep respect and appreciation for whatever they said that was mildly intelligent. Mention that you noticed they invested in Companies  X&Y (boards they are currently on) and you thought they might be interested in taking a look at your company because it’s in the same sector they are focused on and has a very promising approach to the market.  Attach your 2 page summary to the e-mail.
10. If they respond, follow up ASAP on whatever they ask you to do (usually to talk with their Associate or someone else at their firm). Congrats, you are in!  Don’t screw it up.  If they don’t respond, don’t bother re-sending your  e-mail 4 times, it’s a “no” and you should move on.   There are plenty of VCs in the sea.

These 10 steps do not guarantee getting a meeting, but if properly executed they will significantly improve your chances.  If you can’t get a meeting after going through all of this, then chances are you need to do some serious work on your idea/company.

Carried Interest Debate Cont.: The Death of Sweat Equity?

Fred Wilson has a post up this morning on the carried interest debate in which he advocates taxing all carried interest as ordinary income.  As I mentioned in my own post last week, while I think that the evolution of the investment management business argues that some changes to the tax treatment of carried interest are theoretically justifiable, I do not believe that a wholesale condemnation of carried interest is justified or advisable.

At its heart, the critics of carried interest appear to be unwilling to recognize that it's possible to make an intangible investment.  This is a kind of strange argument to make, especially for VCs, given that the concept of intangible investments is deeply ingrained in the venture capital industry where VCs routinely grant multi-million valuations to start-ups that have little more than some "sweat equity" and "intellectual capital" investment in and while these things don't show up on a balance sheet (or a tax return) they are routinely accorded significant value and in many cases end up producing substantial profits (which in most cases are taxed at a capital gains rate).

The issue most of the "anti-carry" crowd seem to have with VCs is that they either A) aren't willing to concede that VC's make any significant intangible investments in their partnerships or B) are willing to concede that they make intangible investments but believe that the management fees they receive mean that they were already well paid to make those investments, so those contributions shouldn't be viewed as investments, but just part of the job.

As I mentioned in my prior post, I am actually somewhat sympathetic to the arguments underlying B), but those arguments do not hold water across the board spectrum of potential GP/LP scenarios. While it may be hard for people to recognize the value of intangible contributions in the case of a VC or PE professional who is pulling down millions in management fees,  it's pretty easy to see this in the case of a small businessman who is investing their time and expertise (and receiving $0 in management fees) to make a restaurant a success or to renovate an apartment building. And if that person is deserving of capital gains treatment for their sweat equity, then why shouldn’t a VC that agrees to operate under similar terms receive capital gains treatment on any profits produced?

I believe that our tax code must favor not only those who invest straight cash, but also those who take real risk and invest their time and other intangibles.  Without the ability to allocate profits on the basis of both tangible and intangible contributions, a lot of skill rich/cash poor folks will be a significant disadvantage to the rich folks that control all the capital as they will be the only ones to get capital gains treatment.  The real irony of the “anti-carry” crowd’s position is that their logic ends up penalizing labor by reserving beneficial tax treatment only for the providers of capital, something that seems entirely inconsistent with the underlying sentiments of the “anti-carry” crowd.

Finally, I think that the “anti-carry” crowd fails to appreciate that limited partnerships are businesses in which the LPs effectively invest in the GP to help make them money. The LPs invest in the GPs because they want access to their intangibles (sweat equity, connections, intellectual capital, etc.) and they give the GPs a disproportionate share of the profits in direct recognition of the value of these intangible investments. From a theoretical perspective this is basically no different from an investor who buys shares in a corporation at a price above tangible book value.  There is basically zero difference between an Limited Partnership and a Corporation from an operating perspective, yet for some reason the “anti-carry” crowd wants to subject profits from one to a different tax treatment than the other. This makes no sense unless you are either A) intellectually lazy or B) your real intent is to abolish capital gains treatment on all profits regardless of what the legal structure of the entity that produces them is. It is a very slippery slope for anyone who really thinks about this in an intellectually honest way.

Put another way, let's say there is a VC that does not take any management fees, but still works works hard for 5 years to get a successful outcome on an investment. Can anyone say with a straight face that the VC has not made a substantial investment into that entity even though no cash has changed hands?  I realize that management fees are (or at least should be) the big issue here because they negate in theory and reality both the "risk" and the "investment" nature of the time that the VC spends, however it is very interesting to note that entrepreneurs (and many corporate managers for that matter) not only get sweat equity stock but also get salaries and benefits and yet no one is saying that the capital gains on the sale of their stock should be considered ordinary income. Why should a VC be treated any different? They take the risk of starting a business (an investment management business) and then get investors to agree to a deal in which they get a disproportionate share of the profits relative to the actual capital invested (just like entrepreneurs do). Yes, they get a salary, but so do entrepreneurs and employees at normal companies and yet no one is talking about killing off their cap gains treatment ... at least not yet.

Yahoo Buys Rivals From $75M More Than Their 2001 Offer

Yahoo apparently agreed to buy Rivals.com for $100M today and that brought me back down memory lane a bit, so I thought I would share.  In Q1 2001, Rivals was hemorrhaging cash and appeared to be on its last legs.  The site was still attracting a lot of traffic and producing very high quality content, it's just that their cost structure was way to high.  At the time, Yahoo stepped in an offered to buy Rivals for $25M in cash but they proposed a incredibly complex structure designed to somehow keep the near term losses off of their books.  That deal fell through (like so many "rescue attempts" did in 2001) and the company was basically liquidated by the VCs.

Fast forward 6 years later and Yahoo is laying out $100M in cash for a newly revived Rivals.  From what I understand, the founder bought out all the assets in 2001 and restarted the company with a non-bubble cost structure and mentality.  Six years later he is rich man and Yahoo is out an additional $75M because they let a bad cost structure distract them from the reality of a great product.

For me, a deal like Rivals reinforces some great investment lessons:

1)  Even if good products are damaged by bad business decisions, they are still good products.
2)  The time to buy is when everyone else is selling.
3)  You can always reduce expense more.
4)  Don't give up on a good product too soon.

Congrats to any of the original Rivals team for sticking it out.  That's what being a passionate entrepreneur is all about.

The Tax Man Cometh: Carried Interest, Risk, Fees, and Taxes

So there’s a move a foot by some within Congress to tax all carried interest as ordinary income instead of capital gains.  In case you aren’t familiar with the term, carried interest is the share of profits that the general partner within a limited partnership receives. Traditionally, all of the profits generated by a partnership  have been treated as capital gains so long as the investments that generated the profits have been held at least a year.  This means that general partners in VC, Private Equity, or Hedge funds (funds which typically are structured with a carried interest) not only get highly leveraged returns on their own investments, but that any profits produced get very favorable tax treatment (15% vs. 35%).

A Bad Way To Deal With An Admitted Problem
Originally I was going to write a post about how this idea would require a complete rewrite of the tax code and how at its heart it’s a Marxist attack on capitalism, but I figure that A) it would be seen as entirely self serving (which to some degree it is)  B) I don’t think it’s going to happen as currently envisioned given how many feet the government has to step on to make this change happen.

However the more I thought about it, I think it should honestly be said that the proponents of such measures have a few decent points which I think that the entire investment community, in an honest moment of reflection, should probably admit as valid.

Before I do so, let me first state that it would be crazy (and highly impractical/improbable) for the government to enact a blanket change to the tax treatment of the profits generated by the General Partner in a Limited Partnership.  Limited partnerships exist for a very good reason: they are an efficient vehicle for making highly productive capital investments that generate future economic growth and tax revenue.   This growth effect is why Limited Partnership investments and most other forms of capital investment, very sensibly, get favored tax treatment.  In a country with a negative savings rate, we need to do all we can to spur investment.  In addition, while the General Partner’s clearly get great leverage on their investment (usually 20/1 sometimes even 50/1), they are not just risking their own capital, but they are making a substantial investment of “sweat equity” which the limited partners obviously feel is very valuable.  If general partner’s are prepared to take the risk of a 100% loss on not just their money but also their “sweat equity”, there’s really no reason in a capitalist society why their investment shouldn’t be treated like any other capital investment.

Risk Based Investing Without The Risk
That said, as fund sizes have exploded in the last 5 to 10 years, the level of risk that the General Partner is really taking has arguably declined dramatically because the fee income for many funds has become so huge that many of the general partner’s will make a ton of money even if their fund is a total disaster.   After all, it’s hard to claim you are risking a lot of “sweat equity” when you are driving around in an air conditioned Bentley.

For example, in the VC industry if you go back to 1990, according to the NVCA the average firm size was $82M and they had an average of just over 10 “principals” at the firm (10.2 to be precise).  With a 2% management fee, that pencils out to about $164K in management fee revenue per principal, and that’s before all operating expenses.  With fund sizes this small, the general partners were clearly not living high on the hog when it came to management fees.  In fact, if the funds didn’t make a decent profit it would be safe to say that the opportunity costs for most of the partners at the funds would have far outweighed any fund returns.

By 2002, the average firm size had risen to $284M, but the average principals per fund had actually dropped to 9.5.  Five years later I don’t know what the exact figures are, but my guess is that the average is now above $300M and the number of principals has either stayed constant or gone down, but average management fee is now probably closer to 2.5%.  What that means is that at the average firm now generates $789K/year in management fees per principal and many of the top firms (ones in the so-called 3/30 club) have funds under management of well in excess of $1BN, 3% management fees and just 5-10 full partners.  Such funds can and do pay their partners $2-$3M a year before the investors get a single penny back.  Many of these funds also pay the capital contributions of their partners out of management fees meaning that the individual partner’s never even have to write a check into the fund.

Under these circumstances it’s not hard to see how venture capital has become a fairly riskless proposition for many GPs and that it’s pretty hard to argue folks are investing a lot of sweat equity when they are pulling down at least a million dollars a year for getting out of bed in the morning.  Put another way, in a 3/30 $1BN fund, the general partner only has to put up $10M but in return is guaranteed to get at least $150M in fees over just the next 5 years.  With numbers like that, it’s hard to argue that the partner’s are really taking any risk at all and if they aren’t taking any risk then why in the world should they get any favorable tax treatment for their “sweat” equity since they clearly aren’t sweating the risk of a loss.  If they do lose their share of the $10M they can just fly in their private jet to their beach house Maui to console themselves.  The situation is even more pronounced in the private equity world where fund sizes are now racing past $10BN.  At this level, the compensation for partners at many private equity fund’s makes VCs look downright parsimonious.

So while I agree with and strenuously defend the principle of affording capital gains treatment to those general partners that are willing to take the risk of investing their own cash and sweat equity to produce returns, I think the reality is that in a large number of institutional funds today (be they VC, Private Equity or Hedge Funds), the principals are really not risking much if anything and are pretty handsomely compensated for the time and energy they spend on their portfolio investments.

A Modest Proposal
All that said, the solution that government is proposing is, as usual, terribly misguided.   Taxing all income to general partners as ordinary income is a sure way to A) unfairly penalize those limited partnerships where the general partner really is taking a significant risk and investing a lot of sweat equity (which usually are small business partnerships focused on things such as restaurants and apartment buildings) B) reduce the overall level of private investment C) hurt the businesses that depend on this investment capital for growth.  While I think that a blanket change in the tax treatment is bound to have these negative effects, there are some other changes Congress can make which insure that general partners really are taking real risk and investing real sweat equity to help growth the economy such as:

1. For tax purposes, reduce the general partner’s tax basis by the amount of after-tax management fees it pays out to its members.  In other words, if an individual partner invests $1M in the fund, but gets a salary from the fund that generates an after tax income of $1M, then that individual’s basis should be reduced to zero, which effectively means they invested nothing and should therefore have to pay ordinary income taxes.
2. Raise the % of the fund that the general partner needs to contribute to qualify before it qualifies for capital gains treatment from 1% to 5%.   This makes the level of risk for the general partner a lot more meaningful.  One major drawback of this approach though is that general partner’s without a lot of cash will be hard pressed to meet stiffer capital requirement and this might unfairly advantage old rich firms over new upcoming ones.
3. Some combination of 1 and 2.

These changes increase the level of risk and neutralize the risk reducing effects of copious management fees.  Firms can still choose to pay their partners a ton of money, but if they do those people will lose favorable tax treatment on their investments unless they are willing to invest a lot more cash.  This kind of dynamic tension between current income and capital investment risk is exactly what LPs face, so why shouldn’t GPs face the same trade-off?

It's All About the Benjamins
Of course, the real agenda in congress is not fixing the limited partnership incentive structure, but finding an easy way to raise several billion in additional tax dollars, so I really don’t think the Congressmen care that their proposals are likely to backfire and are logically inconsistent with both capitalism and the fundamental philosophy behind our tax code; they are just trying to make a quick buck by alienating a few as people as possible while wrapping the whole exercise in some media-friendly populist pandering.   Might be good politics, but it’s bad policy.

Private Equity's Software Buying Binge

In 2004 there were, by my count, about 18 acquisitions of public software companies and Private Equity firms made none of them.  By 2006 however, not only had the number of acquisitions risen to 32, but Private Equity firms accounted for 25% of them, up strongly from 11% of deals in 2005 (See table below).

                               

Year	Total Deals	PE Deals	% PE
2004	18	0	0%
2005	27	3	11%
2006	32	8	25%

At this rate I wouldn't be surprised to see private equity account for over 50% of deals in a couple years.

Who Said Maintenance Revenues Aren't Beautiful?
Private equity firms have taken a liking to software firms not because they believe software to be a great growth market but largely because most software firms have what PE firms might call "immature" balance sheets, with little or no debt and relatively high levels of cash.   Rather than targeting fast growing software firms, PE shops typically target "mature" software companies as they not only tend to have lots of cash but they also derive a large percent of their revenues from maintenance revenues.  These revenues are seen by private equity investors and, more importantly their lenders, as a stable source of cash flow that can be used to finance lots of debt.

Seven Steps To Carry
The basic private equity software play book goes something like this:

1. Buy software company
2. Do dividend recap in which you simultaneously lever up the balance sheet and dividend out all the cash you just borrowed plus most of the existing cash on the balance sheet.
3. Raise new fund off of massive IRR created by dividend recap.
4. Do lots of acquisitions to make organic growth impossible to discern
5. Raise prices, slash R&D, increase sales and marketing.
6. Take company public/sell it at same PE you bought it for to investor/large company apparently unfamiliar with the concept of enterprise value.
7. Repeat.

Now I admit this is a bit of snarky characterization of PE software deals because software offers some unique scale effects in SG&A, but I think this characterization is probably closer to the truth than a lot of mumbo jumbo about "value add" "synergies", etc.

And the Winner Is....
For my money,the most notable (and most ironic) private equity buyout of public company in 2006 was the acquisition of SSA Global by Infor. Why?  Because SSA Global was itself a private equity sponsored roll-up of public software companies (including Baan, Ironside, and Epiphany) which was public for all of a year before it was bought by another private equity sponsored roll-up of public companies, Infor, which now rather immodestly claims to be "the fastest growing enterprise software company in the world".

To have the two companies that are following the private equity playbook to a T merge with one another after the first one was only public for a year is just priceless.   I can't wait to see the prospectus for Infor and how they back up their claim to be the fastest growing enterprise software company in the world, it should be a classic.

A GOOD Exit: Good for VCs, Bad For Microsoft

Mobile E-mail middleware provider Good Technology was sold to Motorola yesterday.  I have written about the mobile e-mail middleware market in the past and the vast sums of VC money that it has consumed.  Good consumed the most of anybody, almost $250M and had a long roster of some of Silicon Valley's finest as investors.

As good as Good was at raising money it was apparently even better at spending it.  I got a call in May from a retail broker, of all people, pitching me on the virtues of Good's Series E or F or Z (I can't remember) and this was less than 3 months after they had announced raising another $20M.  Not only was I dumbstruck that a retail broker was pitching Good's stock as though it were the stock de jour, but I was equally stunned that they were out looking for money only 3 months after raising $20M and only 15 months after they had closed another $65M.  I'm no math major, but if you raised $85M in 15 months and are already looking for more, you are probably burning $4-5M/month.  I guess I'll never know exactly what they were burning a month because I declined to go the San Francisco Airport Marriott and hear their pitch with whomever else this broker had rounded up off the street.

Not that it matters either as the Silicon Valley rumor mill (at least the part I am plugged into) puts the exit value at around $500M, give or take some escrow and indemnities here or there, which means that Good's investors actually made out, well ... good, real good.  Of course that could be totally wrong, but it's now being reported by respectable news organizations so it sounds like it is a good number.

A 2X To Be Proud Of

A 2X on $250 in PIC might not seem like much, but from my perspective it is absolutely heroic given that there's a very real chance that Good would have been out of business in a few years if not a few quarters.   No they wouldn't be out of business because they had run out of money (they were apparently too good at fundraising to do that), they would be out of business because Microsoft has started literally giving away the same functionality, the only catch, and it's admittedly a big one, is that you have to have a phone with Microsoft Windows Mobile on it.

Its' Hard To Compete With Free And Easy
I just so happen to have such a phone (the Treo 700wx) and was amused to find when I first powered it up that Good Technology's software was prominently displayed on the phone and offered as a solution for accessing my Exchange server.  So I faced an excruciating dilemma:  I could either A) Pay Good a $30 a software license and then pay my hosting company a monthly service fee of $20/month or $240/year (per phone mind you) or I could B) Get the same exact "push e-mail" functionality as Good offers absolutely free by taking 1 minute to enter my exchange log-in details into my phone.  No software to install, no bills to pay. Needless to say this was not a hard decision.

However if one did not know that this functionality was released by Microsoft in Q1 06 for free and yet desperately wanted "push e-mail" functionality, there's a good chance you would dutifully sign up with Good and pay them there $240/year.  It's not like Sprint, Good or my hosting provider went out of their way to mention this, after all they are all getting a piece of the action and thus don't have a big incentive to point out that I am wasting $270 on them.

I should point out, that since that time (a couple months ago) my hosting provider has actually had a change of heart (most likely prompted by a heart to heart with some lawyers and some very angry phone calls from customers who found out they were duped into wasting $270) and has now posted on their site a comparison of the three push e-mail solutions they offer which you can view here.   For those too lazy to click through, the link is to a page that shows the three push e-mail solutions offered by my hosting provider: Blackberry @ $50 up front and $10/month, Good @ $30 up front and $20/month and Microsoft @ FREE.  Now I am not a market researcher but my guess is that once you explain to people that each service is roughly equivalent, that about 100% of the people who have a Window's Mobile phone will pick Microsoft and a decent chunk of people who own other phones will go out and buy a Windows mobile phone while the rest will resolve to buy such a phone next time they upgrade.

Which brings me back to why Good's exit is so damn good.  To get $500M for a company 6 months AFTER the death warrant for its main product line has been very publicly signed, sealed, and delivered from Redmond, WA is absolutely awe inspiring.

Hello Moto ... Hello
While the exit left me with tremendous respect for the VCs, it also left me wondering what in the world the folks in Schaumberg, IL were smoking.  At first I thought they just were either desperate, drunk, or filled with wild-eye RIMM envy.   Then I figured it was all three, but then I thought a bit more about it and realized that Motorola's purchase really didn't have anything to do with RIMM (despite the fact that every news account under the sun characterized the deal as primarily motivated by a desire to compete with RIMM).  No, what this deal was about was freeing Motorola from Microsoft's potential stranglehold on the OS software for their smart phones

After all, Motorola already knows full well that Microsoft offers the same functionality as RIMM and GOOD for free.  One can imagine that their Microsoft reps trumpeted this fact to them to no end while they were putting the Q together and gleefully told Motorola of their grand plan to destroy both companies through their time tested strategy of giving everything away for free.  In fact, there's a decent (and highly ironic chance) that Microsoft was so convincing that they literally scared Motorola into paying a huge premium for what they knew was dying asset as this was the only way to insure that they would be have the flexibility to compete with RIMM and Nokia (which bought Intellisynch last year) without having to throw itself at the mercy of the merciless Microsoft.

In Linux We Trust
Thus by buying Good, Motorola now has the freedom to develop and ship Linux-based smart phones (such as Ming) that can still play ball with push e-mail (using a familiar "brand" no less) without having to pay a significant tax to Redmond on each phone.  I am not sure what that's worth but I suspect there's a spreadsheet somewhere inside Motorola's headquarters that multiplies that tax by the number of smart phones they expect to ship over the next 5 years and that this spreadsheet was the main one used to justify the deal or at least the main one that Ed Zander, someone who knows a lot about competing with Microsoft, used to justify the sky high price to himself.  Of course, I could be wrong and the folks in Schaumberg could just be filled with blind RIMM envy or drunk or whatever, but I think they deserve the benefit of the doubt.

Whew! That was a Close One
As for the VCs involved, I suspect there are a lot of happy and relieved looks around the Good boardroom these days for no one could see the oncoming train better than they could.   It may not be "Google Style" money, but it's more than respectable and considering the circumstances, downright impressive.

Launching Inductive Capital ... Finally

Well it's October 1st, the beginning of Q4 2006, and I am happy to announce that I have finally launched Inductive Capital, a investment fund targeting public technology companies.  This may seem like a bit of a departure for many who know me primarily from my days as a VC, but those of you who know me from my days as a Wall Street analyst will probably not be all that surprised.

Before I go any further, I should point out that the reason I haven't blogged since mid-April is that as soon as I took the first serious steps to put this fund in place my lawyers advised me that I should stop blogging in order to avoid any chance of running afoul of a number of investment regulations.  (Incidentally, my lawyers are probably the biggest most respected hedge fund lawyers on the West Coast and believe it or not they did not have a single client that had a blog, so needless to say they were a bit hesitant to let me blog with abandon.)  Since Inductive Capital is a hedge fund, and therefore considered to be perpetually in registration, I still face many legal and regulatory restrictions which unfortunately will keep me from writing about the activities of the fund.  I also need to be especially careful to avoid writing anything that could be construed as fund raising for the fund or trying to provide investment advice, so just so we are clear this post is intended as nothing more than update to everyone who reads my blog on what I am doing now.

I want to be equally clear that I intend to continue this blog from now on and pretty much continue to write about what I have been writing about in the past.  I suspect I my have some commentary on the hedge fund industry from time to time, but given that my new fund will continue to be deeply embedded in the high-tech venture capital space I will continue to write about venture capital and interesting new technology trends.  About the only thing I did in the past that I won't be doing now is publishing lists of stock picks, such as my Virtual Stock Portfolio, or offering any kind of investment advice.

What exactly am I doing?  Well I am running a long/short, low net exposure investment fund, otherwise know as a hedge fund.  The investment thesis behind the fund is something I am particularly passionate about and something that is directly based on my experience as both a VC and a Wall Street analyst.  To put it briefly, the fund has been designed to collect information and insights from the private technology market and then try to apply those insights to help make investments in the public market.   Helping me to collect those insights and information is a formal advisory committee composed mostly of VCs and a few other members of the VC-funded ecosystem.  My advisory committee is composed of a great group of folks, all of whom I deeply respect, and I am also lucky to have a great group of investors many of whom have tremendous experience in both the private and public markets.

I named the fund Inductive Capital primarily to reflect the fact that almost all investment decisions are based on inductive logic and this is especially true of a fund that seeks to apply private market insights to the public markets because you must gain multiple data points from a variety of angles and them filter them based on judgement and experience before you can have any confidence that your reasons for making a particular investment are reasonably sound.

Why did I decide to do a public fund instead of staying in venture? Well it honestly was a tough decision, but I think in the short term there are number of very interesting trends that created a real opportunity for a fund such as Inductive and I was compelled to take advantage of that window of opportunity.   Over the long term I am pretty convinced that the VC world and hedge fund world will increasingly overlap so hopefully my absence from the venture capital world will prove only temporary.

Anyway, enough about me and my new firm.  I look forward in the coming weeks to doing some posts on topics I have covered in the past as well as a few new ones and I hope that everyone who has read this blog in the past will continue the dialoge with me as I really enjoy the interactions.

Cash Rich vs. Cash Poor VCs

One of the more interesting dynamics developing in the VC industry these days is the emerging battle between “cash rich” and “cash poor” VCs. Generally speaking, “cash rich” VCs are any VC with a fund larger than $500M while “cash poor” VCs usually have funds smaller than $200M.

Have Cash, Will Spend
Just like entrepreneurs that have raised a lot of money, VCs with large funds tend to be relatively loose with their cash.  Not only do they find it easier to write larger checks up front, but they usually have a lower bar for “doubling down” on their investments and putting up more cash.   In comparison, small VCs tend to be much more focused on the capital efficiency of their investments and can often take a frustratingly long time to work up the courage to write what seems like a small check.

Left to do their own separate deals, “cash rich” and “cash poor” VCs can co-exist in relative harmony, however when you mix the two together in the same deal it’s often a recipe for some real fireworks, the potential for  which tends to increase exponentially the closer the company gets to running out of cash.  For “cash rich” VCs, having an investment run out of cash, even one that isn’t performing that well, isn’t that big a deal (in some respects it’s actually a welcome occurrence).  After all they generally have more than enough cash left to invest and can therefore easily “afford” to double down and wait for things to potentially get better. 

In contrast, for “cash poor” VCs, having a company run out of money is a major issue that may require them to write a very large check relative to the size of the fund.  To make matters worse, if they don’t write the check there is very good chance that their ownership stake will be wiped out by “pay to play” provisions.  Faced with this dilemma, many “cash poor” VCs will push aggressively for a sale of the company.   Large VCs though usually oppose such a sale because even if the company can be sold for a profit the profit won’t be large enough to “move the needle” at their fund.

Not Selling Wine On Time?
The tension between these two camps can lead to some pretty spectacular clashes.  For example, a number of former employees/investors in Wine.com are currently suing the lead investor, Baker Capital, alleging that Baker purposely turned down a $67.5M buy-out offer from Liberty Media in mid-2005 so that Baker could instead do a $10M “cram down” round a few months later and wipe out the other investors.  Baker claims the offer wasn’t real, but apparently there was a signed term sheet on the table, so it looks like they are headed for an interesting court battle.

If legal precedent is any guide though, the small investors in Wine.com face an uphill battle.  That’s because the courts have already addressed this issue, most notably in a case that Benchmark filed against CIBC when CIBC washed them out of Juniper Financial.  Benchmark's suit was subsequently tossed out by a judge in Delaware who basically said "you’re a big boy, you knew the rules when you put your money in so stop complaining".

A Few Words of Advice
Given that this tension between “cash rich” and “cash poor” VCs is real and is likely to only get worse, I have a few pieces of advice:

• For Entrepreneurs:  When raising money, do you best avoid mixing “cash poor” and “cash rich” VCs.  Discuss exit expectations with all investors in advance of taking their money and discuss them at regular intervals once everyone has put their money in.
• For “cash rich” VCs:  Choose your co-investors wisely.  Let the other investors know you investment style and intentions in advance so that there are no misunderstandings.  Talk to a lawyer, for a long time, before you decide to cram down everyone else.
• For “cash poor” VCs:  Pay careful attention to the other investors you are investing alongside of and recognize that when you invest alongside the "big boys" everyone, including the courts, expects you to play by the big boy rules

Are VC Funds Getting Too Big For Their Own Good?

I’ve recently had very similar conversations on separate occasions with a number of different entrepreneurs.  The basic gist of these conversations, which Peter Rip touches on in his own post, was that the interests of VC funds and entrepreneurs seem to be diverging more than ever thanks to several trends, the most important of which is the increasing size of VC funds.

Problems On the Way In...
Large funds are creating both entry and exit problems.  On entry, large funds create problems because they are under pressure to invest as much as possible in each deal in order to preserve the operating leverage of the fund.  This means that it’s increasingly difficult for entrepreneurs to assemble a syndicate of VC firms as each firm wants 100% of the deal from themselves.  Syndicates are important for entrepreneurs because they disperse control and leverage multiple networks.  More importantly, the VC’s desire to put as much money to work as soon as possible often results in very significant up-front dilution for entrepreneurs.  Many VCs now say that they have minimum initial investments, usually around $3 to $5M, which can give the entrepreneur a frustrating choice between no funding and too much money with too much dilution.

... and Problems On The Way Out
On exit, large funds once again can cause problems because the funds are heavily biased towards “pressing their bets” and trying to get a home run vs. selling out more quickly for single or double because singles and doubles on $5M don’t “move the needle”.  Thus, entrepreneurs often find VCs dragging their feet on potential M&A deals because they don’t think a smaller early return is worth the time and capital they have invested.  On the other hand, many entrepreneurs want to sell out early because the money on the table is significant from their perspective and they are worried that in going for the home run they may ultimately strike out and end up with nothing.  Put another way, entrepreneurs don’t have the luxury of portfolio diversification so a bird in hand is as good as five in the bush.

These tensions are being exacerbated by two other trends.  The first is that thanks to dramatically lower technology costs in some sectors, it often takes less money to get a company off the ground than it has in the past.  Thus, VCs are paradoxically looking to write larger checks into industries that actually need less money.  Second, exit valuations have become more predictable and less rich which means that dilution stings more than ever.  Giving up 50% of a business that could be worth $500M in a few years is a lot easier than giving up 50% of a business that will likely on be worth $25-$50M.

The Bad News and The Good News
The bad news for large VC funds is that if my recent conversations are any guide it seems like more and more entrepreneurs are picking up on the implications of these dynamics and adjusting their behavior accordingly.  These changes could lead to a serious case of adverse selection, wherein the best entrepreneurs with the most capital efficient ideas either self-fund or raise money from angles while only relatively risky ideas with large capital requirements seek capital from large funds.

The problem for entrepreneurs is that there’s not a lot they can do to change the behavior of the large funds.  For the most part these funds are behaving rationally and really couldn’t change how they behave if they wanted too given the economic incentives/restrictions they face.  The good news is that for those less sensitive to dilution there’s a lot of money out there and it’s easier than ever in some respects (save perhaps Q1 2000) to raise a large amount of money if you need to.

If It Fits, Sign It
The best advice that I would have relative to this trend for an entrepreneur is that if you have the luxury of choosing your VC firm, you should try to pick a firm whose financial interests are best aligned with your own and not necessarily the best “name” or the best price.  If you have an idea that will take a lot of money to get off the ground and if success if more important to you than money, you are probably best off taking money from a large firm as they are not going to sweat writing big checks and will likely be more patient than the average VC.  If you have a very capital efficient idea and are interested in making money as soon as possible I suggest you go with a small VC firm whose investment in your company will be material enough from their perspective to align everyone's incentives.