Respecting Failure

October 28, 2010

By: Paul A. Jones

If you don’t think that respect for failure is one of the things that distinguishes places like Silicon Valley from places like Wisconsin , check out http://failcon2010.com/ – a Silicon Valley conference dedicated to dealing with, recovering from and learning from entrepreneurial failures. This year’s event, held on October 25, attracted over 450 folks, and by all accounts was a great success, if that word makes any sense in describing an event about failing. Don’t look for next year’s event at a Wisconsin location near you. Failure here, as an entrepreneur/friend of mine told me recently, isn’t something you learn from and build on, its more likely something that dogs your career and reputation – business and social.

I am not suggesting that failing is something to celebrate, as such, or that entrepreneurial failure is somehow pleasant for those who experience it. But let’s face it, any entrepreneur who has ever experienced great success – say, for example, Steve Jobs – has also experienced failure: gut-wrenching, “what was I thinking,” soul-searching failure. I know I have (just ask me about the business plan I buried in my front yard some years back). And as for Mr. Jobs, do you remember Next? Or Newton ? Or Lisa? And the jury’s still out – it’s been how many years now? – on Apple TV.

Indeed, one of the things that distinguishes most successful entrepreneurs from most, well, failed entrepreneurs, is how they handle failure. The ones who overcome failure tend to be those who don’t shy from confronting their failures. The one who takes the time to ask themselves what they might have done differently (or not – some failures are after all beyond the entrepreneur’s control). The best entrepreneurs I have met have also been the kind who are quite willing to share their encounters with failure with others.

Successful entrepreneurs have huge egos; so huge that they are not squeamish about their mistakes and failures, and, in fact, anxious to learn from them. And maybe, at a suitable emotional distance, even find some gallows humor in them. For me, the darkest moment in one of my failures was the sudden realization that, contrary to popular belief, it is actually always darkest just before it turns pitch black.  It wasn’t very funny at the time….

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Posted by pajones1

How Much Is That Startup in the Window. Really.

October 26, 2010

By: Paul A. Jones

In an earlier post, I suggested that high impact entrepreneurs wondering how much their startup was worth – how much of the company they will need to give up in exchange for how much capital – should start by looking at the comparables. How much are more or less similar startups getting in the market? And how more or less similar are those startups in terms of team, market, technology and, alas, location (all other things equal, the further a startup is from a major venture capital center the less it generally will fetch). In this post, I am going to try and suggest a valuation model for those who insist on a more quantitative approach.

First, it’s important to remember that the finance theory gold standard for valuing a business is discounted cash flow analysis. It’s pretty simple in theory – put together a model of how much cash goes in and how much goes out over a period of time, assuming at some point a handful or two or three years out the number becomes a constant positive from year to year, and then pick a suitable discount rate to reflect the risk (at least 30-50% for a startup) and figure out the “net present value” of that cash flow stream on day one.

Alas, this is one of those cases where theory and reality don’t get along very well. For a variety of reasons finance theory just isn’t used much when the pros try and value a high impact startup investment opportunity. First, there are just too many variables involved; many of the variables are very hard to pin down even within a fairly wide range (how big will a market that may not even exist when the investment is made get, and how fast); and some of the variables are binary (e.g. maybe the technology just won’t pan out at all). Further – and you will have to trust me on this (or email me for a further discussion) – for a variety of reasons mostly related to the structure of venture capital vehicles (closed end funds that draw down capital over time and distribute investment proceeds to their own investors more or less as realized) the timing of returns on a given investment – which plays a huge role in the classic discounted cash flow analysis – just doesn’t matter all that much to early stage venture capital investors. Don’t get me wrong, here; everyone would rather get their return sooner rather than later. It’s just that venture capitalists, and the people who invest in them, are not by and large market timers – or at least that is not how they are evaluated. Rather, they tend to focus much more on how much capital is returned on each investment, typically measured in terms of a multiple of the cash invested, then the timing of the return, at least assuming the return is within ten years of the investment.

Fortunately, there is an at least plausible quantitative approach to valuation that has some utility in the startup context. Fittingly enough, it is often referred to as the “Venture Capital Method.” While various practitioners have their own versions of the Venture Capital Method the basic idea is simple. First, figure out what cash-on-cash return you need on your investment in a given deal. For a startup high impact business, figure at least 10x. Roughly 3-4 times what the typical early stage venture capital fund in a “normal” market might want to earn on its entire portfolio. Then figure out how much the company will be worth at a plausible exit. Take a look at what comparable companies are being sold for currently, usually in terms of a multiple of revenue or in some cases profit. Now, figure out what percentage of the exit value the investor will need to get that much out at the exit and, voila, you know the percentage of the company they need to own when they make the startup investment. And if you know that, and the size of the startup investment, figuring the pre- and post-money valuation is a very simple algebra problem.

Of course, it’s usually not quite that easy. Figuring out how much capital, in how many rounds, will be needed after the first round investment can be tedious – though in the age of the spreadsheet not all that tedious.  Remember as well that assuming the deal is working those downstream investors should be taking progressively less risk, and thus expecting progressively smaller cash-on-cash return multiples. And don’t forget any future dilution from other events, such as increases in the employee pool.

The Venture Capital Method isn’t perfect. But within the context of early stage venture capital investing it seems to bring at least some measure of theoretical discipline to the otherwise black art of valuing high impact startup businesses. So long, that is, as everyone realizes that at the end of the day, a startup is worth what a willing investor will pay, and any sane willing investor is likely going to pay more attention to market comparables than fancy formulas.

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Posted by pajones1

How Much Is That Startup in the Window?

October 21, 2010

 By: Paul A. Jones 

For many entrepreneurs, figuring out how much their high impact startup is worth – that is, how much ownership do they have to offer for the amount of money they want to raise – is one of the more obscure nooks of the startup/venture capital world. Almost by definition, high impact startups are so risky – in terms of team/execution, technology, market factors, timing, etc. – that conventional finance tools like discounted cash flow really don’t fit well with the startup valuation task. So, what is an entrepreneur to do? While there are a variety of ways to approach the problem, and a dozen or more rules of thumb, there is one too-often-overlooked approach, and one too-often-overlooked rule of thumb, that stand apart from the pack.

The oft-overlooked approach is one that most people, including entrepreneurs, are pretty familiar with in most parts of their lives, but for some reason don’t think of in the startup pricing context. Comparables. When you want to sell your car, what’s the first place you go to figure how much you should ask for it? Market data, right? Look at what the market is paying for similar cars, and then make a case why your car is worth a little more (or perhaps a little less) than the average comparable vehicle.

While perhaps not as broad and deep as the used car market, the market for high impact startup financings is pretty significant. We are talking hundreds of deals – sometimes thousands – over the course of even weak years. And despite the private nature of these transactions, there is lots of pretty solid data on the terms, including price, of these transactions. See for example PriceWaterhouseCoopers quarterly MoneyTree report (www.pwcmoneytree.com). Or check out the web pages of some of the major Silicon Valley law firms (e.g. www.Cooley.com or  www.wilsonsonsini.com): these firms provide their own quarterly snapshot of venture capital trends, including pricing and other common terms of a wide range of venture capital investments. As unique as every startup may be, it’s the rare startup for which you can’t find some pretty decent comparables data.

Once you know have a feel for what the comparables are pricing at – what the market price is for similar deals – you can think about how your startup might be more (or less) attractive than the typical comparable. For example, maybe you are located in flyover country – fair or not, that’s usually a bad thing, in terms of valuation. Then again, maybe Steve Jobs has joined your team as Chief Design Officer: your value just went up. So comparables aren’t the end of the valuation story, but they are an awfully good place to start.

As for the oft-overlooked rule of thumb, its simple. Nothing, nothing, gives an entrepreneur more pricing power in a valuation negotiation than having more than one interested buyer seriously interested leading the investment in your deal. Beggars, as they say, can’t be choosers. And they pretty much take what is offered. Ditto entrepreneurs who start assuming the deal is done before the investor’s check clears the bank. So, while venture investors will do their best to take your deal off the market as soon as possible in the negotiating process, and (gasp) may even do some calling around with their colleagues aimed at heading off a bidding war, it almost always pays for the entrepreneur to resist taking a deal off the market, usually via some sort of no-shop provision offered up by the venture capitalist, as long and hard as possible.

In a subsequent post I will explore some other high impact startup valuation approaches and rules of thumb. For now, remember that the gold standard approach is the same as it is for cars, houses, etc.: figure out what the comps are. And the gold standard for rules of thumb is equally simple: if you want to have the upper hand in valuation discussions, make sure you’ve got more than one credible lead investor interested in the deal.

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Posted by pajones1

Beyond Madison

October 15, 2010

By: Alexander P. Fraser

In the 15 years I’ve been working with Wisconsin early-stage companies, I’ve always done so in the shadow of Madison. The conventional wisdom is that Madison is the end-all and be-all of technology, innovation and entrepreneurship in Wisconsin. And as a two-time UW-Madison graduate, you will get no argument from me on the importance of UW-Madison as a driver of research and innovation and the role played by the University and its tech-transfer and licensing entity, the Wisconsin Alumni Research Fund (WARF). In the 20 years since I left Madison, the City and region have been transformed by the efforts of the UW-Madison and WARF and the start-up activity that has grown out of those institutions.

The flip side of that conventional wisdom is that Milwaukee and the rest of the state lags far behind Madison in technology, innovation and entrepreneurship. But if you take a closer look beyond Madison, this State has an extraordinarily active culture of entrepreneurship and a plethora of resources for entrepreneurs.

The Madison/Milwaukee comparison is based, in large part, on the dominance of UW-Madison relative to the size of the other research universities in Wisconsin. However, university-based researchers in southeastern Wisconsin have four major research institutions (UW-Milwaukee, The Medical College of Wisconsin (MCW), Marquette University and the Milwaukee School of Engineering (MSOE)) which assist faculty with tech-transfer, licensing and start-ups. Combined, these institutions do not approach UW-Madison’s overall research size, but they significantly exceed $200 Million in the aggregate and have actively been looking for ways to collaborate in research and commercialization.

UW-Milwaukee, in particular, has dramatically increased its focus on entrepreneurship through the creation of the UW-Milwaukee Research Foundation (UWMRF) and the significant investment by the University in new faculty hiring – particularly in the School of Engineering. In the four short years since creating UWMRF, invention disclosures, patent, licensing and start-up activity are dramatically up at UW-Milwaukee, and I can tell you from my work with UWMRF that the research conducted at UW-Milwaukee is both groundbreaking and commercially valuable. Long-term, these efforts will spin-off start-up companies which create jobs, wealth and new start-ups, through the sale of those start-ups to larger companies. A recent example is the sale of an MCW start-up, Prodesse, to Gen-Probe. Many of those investors are busy reinvesting sale proceeds in new Wisconsin-based start-ups.

Outside the university context is where it gets interesting (and from the entrepreneur’s standpoint, unconventional). For many years, “conventional” organizations like the Greater Milwaukee Committee (GMC) and the Milwaukee Metropolitan Association of Commerce (MMAC) have been working on economic development for the region by creating organizations which directly impact entrepreneurs and early-stage companies. Examples are the creation by the GMC and MMAC of the “Milwaukee 7” to foster economic development within the seven county southeastern Wisconsin region. In turn, these three groups and their members spawned the Milwaukee Water Council and BizStarts Milwaukee, each of which (in very different ways) focus on research, economic development and the promotion of new business.

More recently, the Wisconsin Energy Research Consortium (WERC) was launched to foster research, collaboration and economic development in the energy, power and controls fields. WERC includes university partners (UW-Madison, UW-Milwaukee, Marquette and MSOE) along with some of Wisconsin’s leading energy, power and controls companies (including Rockwell Automation, Johnson Controls, WE Energies and American Transmission Company). WERC and the Water Council are unique models nationally – what makes them most exciting for the region is the way they attempt to leverage traditional areas of the region’s strength in “old school” manufacturing as way to promote new business initiatives based on technology and advanced manufacturing.

On the funding side, the market for funding for early-stage companies in southeastern Wisconsin has never been more active – Silicon Pastures and the Golden Angels have been active in the area for many years, and remain so today. More recently, Capital Midwest Fund and Successful Entrepreneur Investors have launched financing resources for very early stage companies.

Every region has its strengths and weaknesses. While it is true that the academic research dollars in Southeastern Wisconsin are not as plentiful as in Madison, we do have strong research universities and the research dollar gap with Madison is shrinking. Where Milwaukee really distinguishes itself in the state is through the use of its more traditional resources – partnerships with industry in particular – to leverage our growing university research. So as an entrepreneur, you sometimes need to look beyond the obvious resources and get the broader picture of what exists in your region. Here in Southeastern Wisconsin, those resources are plentiful and growing, and the excitement surrounding our region’s approach to entrepreneurship is palpable.

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Posted by apfraser

Back to the Future with Super Angels

October 14, 2010

By: Paul A. Jones

Lately, the rise of so-called Super Angels – mostly successful entrepreneurs who first became traditional angels (e.g. investing only their own capital) that are migrating to managing pools of capital contributed by themselves and other successful entrepreneurs interested in early stage venture investing – has been getting a lot of attention. Some people – mostly institutional VCs – are worried about Super Angels encroaching on their turf. Others – mostly early stage entrepreneurs – are more or less pleased to have a new source of early stage capital willing and able to invest smaller chunks of capital than their larger more traditional institutional VC relatives. Which is the more convincing take?

In my view, the Super Angels are indeed filling a funding gap for early stage deals that don’t need millions of dollars to get off the ground. But they are doing it in a way that is far from original, and certainly not a threat to the larger VC community. Indeed, from what I have seen, Super Angels like Ron Conway are not just filling a funding gap that larger funds can’t efficiently fill, they are doing it with a model – a group of individuals (family money) trusting another individual to manage their early stage venture investing – that sounds a lot like the venture capital business circa 1970, doesn’t it? What will be interesting to see is if this new breed of “family and friends” early stage venture capital funds stays true to their roots or, like their ancestors in the early days of venture capital, themselves evolve over time into a new generation of bigger and better(?) VC megafunds.

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Posted by pajones1

The Real Healthcare Reform

October 12, 2010

By: Jonathan M. Fritz and Craig J. Johnson

The U.S. healthcare industry is on the verge of undergoing a decade of transformation – wait … you’re already thinking of the Health Reform bill!No, this column has little to do with the Patient Protection and Affordable Care Act passed six months ago. The real healthcare game-changer came over a year earlier and we are finally about to witness its impact – one that will be far greater than most of us will probably ever notice from the Health Reform bill.

Title XIII of the American Recovery and Reinvestment Act of 2009 (commonly called the “Stimulus Bill”) is called Health Information Technology for Economic and Clinical Health (HITECH) Act. Passed in February of 2009, it created an incentive program to encourage healthcare providers to convert to electronic health record (EHR) systems. Providers who participate in Medicare or Medicaid are eligible to receive significant payments over the next few years by demonstrating “meaningful use” of an EHR system.

The Center for Medicare and Medicaid Services (CMS) released its regulations governing the incentive payments program in mid-July and has since authorized three entities capable of certifying an EHR system as qualifying for incentive payments. The incentive program began for hospitals on October 1 with two of the certification bodies releasing their first batch of certified EHRs and component parts. The program will officially begin for office-based physicians on the first day of 2011.

Participation in the EHR incentive payments program isn’t as optional as it might sound. After the program ends, providers that have not converted will not only have missed out on the incentive money but will also begin receiving lower payments from Medicare and Medicaid, amplifying their competitive disadvantage with those who participated. Through revisions to the proposed rules, the types of eligible providers have been expanded and the standards for qualifying EHR systems have been lowered. As a result, within a few years the vast majority of health care providers will be using meaningful IT systems and gain comfort with the ever expanding relationship between IT and health care.

You may be wondering how this impacts the startup community given that large, established corporations will likely eat up the EHR market. Your skepticism is probably rights – the chances of a young company getting up to speed in this area in time to participate in the program are low, but this is only the first step in an enormous market of IT opportunities for years to come. We know the EHR vendors are going to pave the roads, but the innovative, mobile companies can develop better tires, faster engines and Bluetooth.

Evidence of the emerging marriage between healthcare and IT is abundant. For example, the practice of telemedicine is expected to expand significantly as a result of the Health Reform bill’s emphasis on increased access and cost savings. CMS issued a proposed rule at the end of May streamlining the credentialing process for telemedicine providers at distant hospitals, and the FDA and FCC established a partnership to expand wireless medical technology.

The movement isn’t limited to the public sector. Managed care organizations are experimenting with the cost savings generated by remotely monitoring patient vital signs. Industry giants are forming joint ventures, such as GE and Intel in home health care and Aetna and IBM in Web-based database systems. The Mayo Clinic Center for Social Media was established and recently announced the formation of the Social Media Health Network – an online community of healthcare providers that will share resources related to health related social-networking. Some industries, such as pharmacies, are taking efforts just to make sure they don’t fall behind the blistering pace of technology innovation.

This is just the beginning. Between the Health Reform bill increasing access to healthcare and emphasizing cost savings, and HITECH linking reimbursement rates to meaningful EHR systems, healthcare IT will be utilized in some form by every American in the near future. Putting an EHR system in every doctor’s office is step one, now let the innovators create and capitalize on the next generation of technologies.

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Posted by jonathanfritz

Incentive to Invest (Now!) in C-Corporation Startups

October 11, 2010

By: Craig J. Johnson

The Small Business Jobs Act of 2010 became law on September 27, 2010. The bill contains a wide array of provisions aimed at increasing access to capital and reducing tax burdens on small and startup businesses. One provision in particular provides a tremendous incentive to invest in high impact startup companies while the calendar still reads “2010.”

Section 1202 of the tax code has provided an incentive for long-term investors to purchase stock at issuance by C-Corporations with less than $50 million in assets. If such stock is held more than five years, those investors traditionally enjoyed no capital gains tax on 50% of that stock when it was sold, subject to certain aggregate limitations. The gain on the remaining half of the disposed stock was taxed at normal capital gains rates. The American Recovery and Reinvestment Act of 2009 (commonly referred to as “the stimulus bill”) increased that exclusion to 75% of stock purchased in 2009 or 2010.

The Small Business Jobs Act of 2010 now provides a limited window from now until the end of 2010 during which the purchase of any such stock will be completely excluded from capital gains tax upon its sale at least five years later, subject to the same aggregate limitations. Anyone currently on the fence about investing in a promising young C-Corporation would do well to consider the enormous potential benefit of investing before the end of the calendar year.

The Act contains a number of additional provisions applicable to all types of small businesses, whether a startup or established. For a more complete summary of the Act’s tax provisions by the Joint Committee on Taxation, click here, or to view the bill itself, click here.

Pursuant to the rules of professional conduct set forth in Treasury Department Circular 230, this communication was not written or intended to be used, and it cannot be used for, the purpose of avoiding federal tax penalties.

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Posted by craigjjohnson

Another all-too-common startup mistake…..

October 7, 2010

By: Paul A. Jones

I had an interesting conversation recently with an experienced entrepreneur who recently became the new CEO at a promising tech-driven startup here in Wisconsin. He shared with me some of the “cleanup” needed when he arrived at the company, including several items that needed fixing before the company could seek needed additional financing. One of the items was an all too common mess that delayed the financing for several months, absorbed more than $7,500 of legal fees and, even more frustrating, cost the company a handful of additional equity points to cleanup. The problem? The company had blessed a prior manager with a “no-cut” employment contract: essentially, a deal that said the prior executive could not be demoted or let go other than for cause absent a hefty severance payment.

So what’s wrong with that, you ask. Well, the simple answer is that these kinds of agreements – as common (not really, but to some extent) as they may be for high level execs in the big business world, just don’t work in the early stage world, at least not if the business needs to raise venture or other risk capital. Absent some sort of very special circumstance – I suppose a situation where, say, the executive in question is someone like Bill Gates or Steve Jobs – venture investors (and even sophisticated angels) just won’t invest in companies that have “no-cut” employment deals with team members. Whether you think that is fair or not, it is what it is.

The obvious reason investors avoid deals where team members have “no-cut” contracts is simple: high impact startups are generally cash challenged, very stressful, very fluid environments that reward people – investors and managers – who can move, and be moved, fast and without material financial expense. Related to that, if perhaps more subtle, is another reason: an executive who wants a no cut contract in the startup environment (i) does not understand the “rules of the road” for these kinds of companies and/or (ii) is by nature too insecure to work in the high impact startup environment. Managers who want the kind of security that “no-cut” employment contracts offer just aren’t cut out for the rough and tumble world of the high risk/reward environment of the high impact early stage company.

The take home message here is simple: if you are a founder/co-founder of a high impact startup that will need outside capital, don’t expect a fancy employment agreement, and don’t give one to someone who says that is the price for coming aboard: you’ll regret it later, and just the act of insisting on such a deal is a very good predictor that the manager in question is not right for the job.

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Posted by pajones1

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