Venture Capital and Private Equity: The Same, Only (Very) Different

February 3, 2012

By: Paul Jones

If you’ve followed Presidential politics of late – and as much as I want to look away I find myself gawking at a freeway pileup – you have no doubt heard a lot about private equity and venture/vulture capital. The good news is that much of what you have heard is not true; which, I suppose, is also the bad news. Herewith a brief attempt to provide a little clarity.

First, in a very technical sense, venture capital (VC) is a kind of private equity (PE). Both terms refer to pools of capital assembled by professional management/investment teams from wealthy individual and institutional investors in private offerings. However, in a practical sense, the VC business is fundamentally different from the PE business. As for “vulture capital,” the term is more of a slogan than a description of a business, but to the extent it somehow describes a business strategy it more often than not makes its appearance in the PE world.

Now, VC and PE investors are both out to make money; in fact, they are both out to generate returns that exceed the returns typically available in public securities markets. They both look to generate those returns by investing in businesses with higher risk/reward profiles than those that make up the vast bulk of securities on the major public stock exchanges. But as to how they expect to generate those returns, VC and PE are typically worlds apart.

Fundamentally, VCs make money by building new businesses. PE investors, on the other hand, generally make money by restructuring existing business. VCs are “clean slate” investors in the sense that they typically invest in young businesses with little or no track record with the expectation that those business will become “the next big thing.” Think Google, as an example of a VC deal that worked, and, say PetCo as a VC deal that failed. PE investors, on the other hand, generally invest in established businesses that have fallen on hard times, or are otherwise perceived as not performing to their potential. Think Hertz as a PE deal that worked and, say, Sears as a PE deal that (so far) has not worked very well.

Some more differences. VCs typically do not assume operating control of the businesses they invest in. They are active investors, to be sure, but fundamentally investors, not managers. PE investors, on the other hand, typically see themselves not as supporting but rather as taking over management of the businesses they invest in. VCs typically invest in businesses with no debt, or in later stage investments with limited debt. PE investors, on the other hand, usually leverage their equity investments by having the business take on debt that substantially exceeds the amount of equity the PE firm invested. Thus, most PE investments are in the form of “leveraged buyouts” or “management buyouts.” Finally, if and when a VC-backed company achieves an exit for its VC investors, the company will almost certainly employ more people, usually a lot more people, than when the first VC money was invested. In contrast, if and when a PE-backed company achieves an exit for its PE investors, the business will more often employ fewer people than it did when the PE investors first entered the picture.

While I have spent most of my career in and around the venture capital world, I am not going to argue that VC investing and investors are somehow better or worse than PE investing and investors. They both have their place, which, I think, can be summarized as follows: VC is about creating new value in new vessels, while PE is about salvaging value otherwise locked up in old, deteriorating vessels. The strongest economies excel at both.

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Thinking About Dilution

January 19, 2012

By: Paul A. Jones

For most entrepreneurs, dilution is an ugly word. Being diluted, after all, is about giving someone else a piece of your business. All other things being equal, that’s not a good thing. That said, for entrepreneurs that need third party risk capital to fund their business, dilution is inevitable. And (the silver lining in the dilution cloud) not always as bad as it might seem.

Entrepreneurs facing dilutive events typically have two concerns, both related to a reduction in relative ownership of the business: loss of management control and a diminished share of the “upside” if the business succeeds. Let’s look at control issues first.

Fear of losing management control to investors is something that keeps a lot of entrepreneurs up at night. Too often, though, the fear assumes that there is some magic number – usually 50% ownership – around which control pivots. Alas, it is not anything like that simple. The (possibly disturbing) fact is, an owner of the smallest fraction of a company’s equity (indeed, a creditor without any equity stake at all, though that is a matter for another blog) can have de facto control of a company’s management. And, indeed, venture capital investors with minority ownership positions almost always have substantial management control, as for example rights to prohibit strategic transactions (e.g. sale or merger of the business), limit future sales of equity, etc. well beyond those rights they would enjoy from a simple “who has the most shares” analysis. The devil, in terms of management control, is in the fine print of the deal terms, not the gross percentage of equity owned. The take home here is that control in venture backed startups is more a function of the (hopefully thoughtfully negotiated) finer points of the deal terms than simply a function of who has the bigger/majority equity interest.

As for dilution reducing an entrepreneur’s share of the upside, by definition, an equity investment involves some grant of interest in future profits and/or exit value to the investor. (For purposes of this blog, we’ll assume that the investor’s stake is commensurate with its ownership stake, though it need not be: while an investor’s ownership stake is less likely to diverge significantly from the investor’s ownership share than its control rights, such discrepancies are not uncommon, if not usually as significant.)

Now it is fair enough to say that giving a third party any stake in the ultimate equity value created by the business necessarily dilutes the interests of the prior stakeholders. But the story is more complex than that. Taking on a new investor is a priori (if not always a posteriori) a classic win-win proposition. More specifically, the investor is investing because he believes that the investment will grow in value, while the entrepreneur is accepting the investment ( and dilution) because she believes that the value of her diluted share of the post-investment equity in the business will exceed the value of her (undiluted) pre-investment equity. Unless both parties anticipate a wealth enhancing proposition, there won’t be a deal.

The win-win story is most easily understood in the context of an “up” round: that is, where the new investor pays a higher price than the prior investors. So, for example, an entrepreneur who owns say 50% of a business where the previous investor paid $1.00 per share is demonstrably wealthier if she takes on an additional investor at $2.00 per share even if doing so dilutes her ownership down to 25%. In fact, her wealth (even if not her liquidity) has been doubled (she now owns the same number of shares, each of which is worth twice what it was before the investment).

The $1.00/$2.00 example above does not mean that an entrepreneur should always accept dilution if doing so would increase her wealth. It may be that while the $2.00 offer doubles her wealth, the ownership stake she is selling is worth more than $2.00 to some other investor. What the example does illustrate, though, is that a dilutive event can also be a wealth enhancing event. Indeed, even in a down round scenario (say the price goes from $1.00 to $0.50 per share) the entrepreneur should only accept the dilutive event if she feels that her diluted ownership stake after the investment will be worth at least as much as her undiluted stake if she forgoes the investment.

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Posted by pajones1

Corporate Venture Capital: An Entrepreneur’s Perspective

January 16, 2012

By: Paul A. Jones

While never a dominant part of the venture capital industry, corporate-sponsored venture capital investors (think for example AOL Ventures) have long been an important part of the industry.  Entrepreneurs thinking about seeking venture capital should, preferably at the beginning of the quest, consider whether they want to seek, or will even consider, corporate venture capital.  For some deals, corporate venture capital is a priority; for most it is an option; and for some, it might be a last resort.  Herewith, some of the issues to consider.

Corporate Venture Capital as Deal Validation.  Generally, the more technology risk a deal has, the more attractive corporate venture money is, all the more so when the expected amount of pre-revenue capital needed and time to market are greater. Corporate venture capital is often a plus, for example, in biopharma deals, where technology risk, capital needs and time to market are huge.  Getting a corporate fund in a deal sends a powerful due diligence signal to all but the highest tier traditional funds (they are as a rule less impressed by third party due diligence) that the science passes the blush test.  On the other hand, deals where time to market, technology risk and risk capital requirements are not so great – say, a niche social networking concept – are not likely to get as great a validation enhancer across as broad a range of traditional funds.

Corporate Venture Capital as Lead Investor – Usually Not.  As a rule, corporate funds don’t make very good lead investors.  First, while a corporate fund can be a nice validator, getting too close to a corporate fund can make doing business deals with companies that compete with the corporate fund’s parent harder to do.  If “Competitor A” is your lead investor, “Competitor B” will be understandably more cautious about doing a deal – or even sharing information – with you than if Competitor A is only a follower in the deal.  Further, remember that most corporate funds (there are exceptions: ask) are not “pure return” investor, and thus is not in a good position to set the price – which is one of the important things the lead typically, well, takes the lead on.  (Traditional funds will – quite correctly – discount an entrepreneur’s assertion that a price agreed to by a corporate fund is a fair price, particularly if the corporate fund is not a pure return investor.)

 Corporate Venture Capital: The People Difference.  Not to say that there are not exceptions, and not to say that corporate venture capital professionals are not exceptional in their own corporate worlds, corporate venture capitalists are as a general rule not the brightest bulbs in the venture capitalist universe.  First, compensation at most corporate venture capital firms is generally not as generous/aggressive as at traditional funds that don’t have to “fit in” to a broader corporate compensation system.  If traditional venture capital firms pay more, you would expect they would attract the best people.  Second, corporate venture capitalists, while needing, of course, to earn the confidence of senior corporate managers, don’t have to go through the hurdle of successfully selling themselves to a typically fairly large group of sophisticated investors who specialize in evaluating venture capital professionals as traditional venture capitalists do.  Finally, most traditional venture capitalists – certainly the stereotypical venture capital professional – are folks with big egos who like to make others fit to their rules rather than vice versa.  That’s a personality profile that doesn’t generally fit very well in  below C-level jobs in big business management cultures.  

Corporate Venture Capital:  Here Today, ….  Whether considering a relationship with a traditional or corporate venture firm, one criteria, of course, is how long a fund team  has been around: generally, fund teams that have managed several funds across several investing cycles are more desirable investors than less experienced funds. While there are notable exceptions, corporate venture capital funds don’t as a rule have the staying power of more traditional funds, as in addition to the performance hurdles all funds must overcome to stay in the business over the long haul, corporate funds have some of their own longevity issues.  For example, being pieces (usually small ones at that) of much larger enterprises, corporate funds are subject to the whims of senior management teams that at most companies blow hot and cold on venture capital investing, depending on short-term earnings pressures and more broadly shifting management priorities over the corporate cycle and as senior managers come and go.  Entrepreneurs considering venture capital should, to the extent possible, try to focus on corporate funds that have demonstrated both some staying power and some real success (which, of course, are also good criteria for evaluating competing proposals from traditional venture funds, too).

As noted, corporate venture capital is an important if relatively small part of the broader venture capital industry.  There are, as with traditional venture capital funds, good corporate venture investors and not-so-good corporate investors.  The ideas noted above are offered not as hard and fast rules – for all of them there are exceptions – but rather as a framework for analysis.  An analysis that entrepreneurs are wise to undertake before launching a campaign for venture capital funding.

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Steve Jobs: Concept Precedes Design

October 11, 2011

By: Paul Jones

Among the many tributes to Steve Jobs on his passing, perhaps the most common theme is the man’s prowess as a designer.  And, indeed, from the Mac to the iPod to the iPhone to the iPad (if not so much Newton, or Lisa, or iTV, or …) Jobs’ talent for matching form to function was nothing short of astounding.  Asking his successors at Apple to maintain the standards he set is asking a lot.  But for arguments’ sake, let’s assume they can do it.

Unfortunately for Apple, meeting the design challenge will only get them part way home in terms of living up to their now departed leader’s legacy.  Because as good as Jobs may have been as a designer, he was even better as a conceptualizer: which is to say, his conceptual prowess was at least the equal of his design flair, and while I can – well, sort of– imagine that Jobs’ successors at Apple can design a better iPod, iPhone and iPad, I really struggle with the idea that they will be able to conceive of the next, well, iNext.  And, ultimately (which is to say probably within a year or two or maybe three at the outside) Apple will have to come up with a compelling iNext to keep the Apple juggernaut on top of the tech world for the next few years after that.

Design, ultimately, is a craft, and Jobs was a superb craftsman.  The ability to conceive something utterly new in function as well as form, on the other hand, is the mark of true genius.  Making a better iPad is a big task, but not as remotely challenging as conceiving the notion of the iPad in the first place.  Even conceding that Apple has the talent to live up to Jobs’ standards in the design of the next iPhone, it strains credulity, I think, to believe that anyone at Apple can match Jobs standards and timing in conjuring the iNext.

Look at it this way.  Suppose you had to rank three teams in terms of how likely each was to conceptualize a blockbuster iNext.  Team one was the Apple team with Jobs.  Team two was Jobs, and team 3 was the Apple team without Jobs.  Go ahead, rank them.  Doesn’t your ranking (we all came up with the same ranking, right?) tell you something about Apple’s likely longevity as the center of the consumer technology universe – or at least as the most valuable company on the planet?

 

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What’s in a Name? Protecting Your Start-Up Trademarks

September 28, 2011

By: Jeff Peterson

Most new business ventures are started around a new idea.  The business focuses on a new product, a new service, something that will set the business world alight with the new idea and creativity that the business will bring to the marketplace.  The initial focus of new companies, rightfully so, is on the development of these new products and services and how to best to commercialize them in a competitive marketplace.  Unfortunately, businesses often tend to neglect another key aspect of their company’s property, namely, the intellectual property they have in the name of their company or products themselves.  Oftentimes, the initial inquiry around a new company’s name in today’s markets is whether the domain name is available for the name.  Companies often fail to do more in-depth trademark clearance searches on both the company name and any new product names which will be used in the marketplace.  Just because a domain name is available for use does not mean the company is free to use that name as the name of their business and/or their products.  Other parties may have trademark rights in that name, even if they do not have the domain name registered.  Selecting a trade name for a new company that is both available and strongly protectable can lead to an invaluable asset for the company as it grows in the marketplace.  If a new company does not do the appropriate due diligence on the selection of their name it can lead to painful and expensive name changes of either the company and/or products down the road if problems arise. 

Choosing a name
Oftentimes, a new company will choose a name which is somewhat descriptive of the new goods and services that they will bring to market.  For instance, “Quality Lenses”, or “Optic Technologies” may provide the commercial impression to consumers that the company is related to optical lenses but the marks themselves are so descriptive that any proprietary enforceability around such trademarks would be relatively weak.  This is because, in general, descriptive marks are not available for trademark protection.  Only when a mark has  been used for a long period of time and acquired so-called “secondary meaning” will courts find that descriptive marks, i.e., marks which describe a characteristic of the product or services, are afforded trademark protection.  The term “secondary meaning” stands for the principle that even though the mark is descriptive, the mark has been so widely used for such a long period of time that consumers recognize that the mark has another meaning beside the descriptive one, namely, it is an indicator of a specific source for the good or service associated with the mark.  Therefore, some of the best marks for choice of the name are fanciful or arbitrary marks that do not relate to the product or good themselves.  “Apple” for instance has nothing to do with computers or electronics.  Another good choice for a mark would be a mark that is suggestive of the good or service associated with it.  “Greyhound” for bus transportation is suggestive because a consumer may envision that the bus travels as fast as a greyhound dog.  Selecting a mark that is either arbitrary, fanciful or suggestive, but is not directly descriptive, can provide a business name or product name in which a company can strongly enforce if any competitors enter the marketplace using the same or similar brand.

Clearing the proposed name
It is important for any new company to make sure that the proposed name they are choosing to do business as is free and clear to use.  This clearance must not only be considered for the goods and services the business is planning on offering immediately but for any future expansions either in goods or services and/or geographical areas that the business is planning on expanding to in the future.  Certainly, checking domain name and corporate name availability at the corporate name registration level is appropriate.  Additionally, a company should make sure no other state trademark registrations or federal trademark registrations have been filed or registered on the same or similar mark.  Additionally, a search should be done to determine if any local businesses in the geographic area the company is operating in have been conducting business or offering products using the same or similar mark.  If such pre-existing companies have been conducting business under the same or similar mark, they may have common-law protection for the mark, even if they don’t have a trademark registration.  Working with legal counsel to perform a legal clearance search of the names is something that should strongly be considered by any new company to make sure that their proposed business and product names are available for use. 

Protecting the trademarks
Once a company has selected their business and product names, and have cleared them in a search, the next step is for the company to decide how to protect their new brands.  Fortunately, unlike patent protection, some level of trademark protection is available without undertaking any additional legal filings or expenses.  Just the mere act of using a business or product name in public, in association with marketing goods or services, is enough to obtain common law trademark protection for the mark.  Common law trademark protection is a right under state law and gives a company proprietary rights to prevent others from using the same or similar mark in the same geographical areas that the company uses the mark.  Obviously, the weakness of common law protection is that the protection would only encompass the geographical areas that a company has actually done business in.  In order to obtain more robust protection, a company can register their trademark with either the state or the federal government.  The rights granted with state trademarks vary from state to state, but generally provide the registrant similar protection to common law protection.  Federal trademark registration, however, gives presumptive nationwide rights in the use of a company’s trademark once it is registered.  Once a trademark has been registered with the United States Patent and Trademark Office the owner of the registration is, with few exceptions, the only one who may use the mark in the United States in conjunction with the goods and services for which it is registered for.  Trademark registration may be applied for at any time – even before the mark is in use.  This allows the company to reserve rights to the mark before the associated company name or product is introduced.  Before a final registration can be secured, however, the mark must pass through the registration process and be used.  The registration process can take upwards of eighteen months.  If a new company has enough financial resources it is always a good idea to try to establish a federal trademark registration at least in the company’s name to provide ample opportunities for that company to expand on a nationwide basis while preserving their right to use the mark and enforce it against other parties.

Best practices
No matter how small a new business is, they should always take the time to perform a clearance search in some aspect of the business name to make sure that there are no overlapping domain names or trademarks which would place restrictions upon how the company gets to use its name in commerce.  By performing a clearance search and picking a strong distinctive name, a new company should not run into any major issues which prevent them from using their brand in the future and will provide adequate protection to prevent others from using any brands developed by the company.  No company ever wants to have to change its business name and being forced to change something as important as the company’s name or the name brands of that company can easily spell the end of a new business.

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Posted by jdpeterson2

Serious Patent News: Some Good, Some Not So

September 7, 2011

By: Paul Jones

Any day now, the Senate will likely pass the America Invents Act, with the President’s signature promised shortly thereafter.  The Act will make the most sweeping changes to United States patent law since at least 1952.  By moving the United States from a “first to invent” patent paradigm to a “first to file” paradigm it will align the country with the vast majority of other nations, and will most likely substantially reduce costs associated with documenting and litigating “who thought of it first” questions.  It will also likely impede the formation and growth of innovative technology-driven startups in the United States. Whether that is a good trade off is something reasonable folks can disagree on.

The new “first to file” paradigm has some undeniable advantages; advantages that to some extent will have their most positive impact on smaller entrepreneurial innovators.  Historically, and I can attest to this from personal experience over 25 years of working with emerging technology businesses, the detailed record keeping programs associated with the first to invent paradigm trip up startups and smaller firms more often than they trip up the big players.  And even when a small firm has a plausible “first to invent” case, it often lacks the financial and other resources to make it effectively.

So much for the plusses of the new first to file paradigm. 

In terms of negatives, any good handicapper would have to say that startups and other smaller firms are going to lose more first to file races than they win, for two reasons.  First, they often lack the technical resources to move as fast as their larger and richer competitors in terms of taking an “aha” moment to a robust patent filing.  Second, they typically lack the deep pockets and intellectual property resources of larger businesses, which also make timely, robust filings problematic.  While the net negative impact on innovation by startups and smaller firms of the first to file paradigm can be debated, I have yet to see a cogent argument that the impact will be anything but negative.

As for me, I like the certainty – at least as to ownership – of the new first to file approach, and the likely reduced operating and legal costs associated with that.  And harmonizing United States patent law with the rest of the world has some intrinsic appeal.  Time will tell, though, whether those plusses are worth the price in terms of how the change will likely impact the amount of innovation in the United States.

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Posted by pajones1

Pondering the First Mover Advantage

August 22, 2011

By: Paul Jones 

The so-called “First Mover Advantage” is one of those terms that invites both passionate devotees and passionate skeptics.  The “FMA” posits that an entrepreneur who gets to market first – with a novel technology or business model – has a sustainable competitive advantage over competitors that should predict ultimate victory.  It is a theory that explains a lot: Yahoo!, for example (or even Lycos, if you prefer).  Of course, it doesn’t explain Google quite as well.

The FMA was particularly popular in the internet bubble at the turn of the century.  In those days, convincing a venture capitalist that you had a real FMA would get an entrepreneur most of the way to a term sheet with most venture capitalists.  The term has been in and out of favor since; in when it seems to work, out when it doesn’t. 

My own thinking is that the FMA is a pretty good analytical tool in so far as it goes.  By that I mean that it is best understood as one-half of a much more instructive tool, which I will call the “First Mover with the Most Advantage” or “FMMA.”

Credit for FMMA probably goes best to Confederate Civil War General Nathan Bedford Forrest.  Forrest was a spectacularly successful cavalry general who won many victories over superior forces employing a strategy that he is famously remembered for saying was based on the notion that the force that “gets there first with the most” generally wins the battle.  That was almost always Forrest.

As applied to technology and business model innovation and success in today’s world, FMMA reminds entrepreneurs and investors that being first to market is by itself not the proverbially “sustainable unfair competitive advantage” that venture capitalists and business theorists are so fond of.  Getting to market first is quite often an unfair competitive advantage, but by itself it is not sustainable as such.  Being first to market with a new technology or business model is only a sustainable advantage if you get there with sufficient resources to capitalize on your position.

The real, but ultimately not unlimited, value of the FMMA tool can be seen in the development of the internet search engine business.  Going back to the 1990s, a number of search engines that look more or less like Google in terms of technology and core business model (Google has obviously broadened the model beyond basic search, as have its competitors, and the technology has evolved) got started, including Lycos, Infoseek, Magellan and Yahoo!.  Of these, Lycos could best stake the claim to the FMA in 1994.

But as history tells us – and the FMMA tool might have predicted – Lycos did not emerge as the winner of the first internet search war, but rather Yahoo! did.  Why?  Because Yahoo! was the first company to get to the market first with the most in terms of resources beyond basic technology and business model innovation.  Resources like superior marketing, and the most capital.  Resources that allowed Yahoo! to be the first of the first generation search engines to reach a critical mass in terms of brand recognition and value.

The Yahoo! experience tells us two things about the FMMA strategy.  First, the obvious one: that being first is not by itself enough.  You also have to be recognized and appreciated as such, and that takes another set of resources and skills, and generally lots of them.  Second, and if you keep in mind what happened to Yahoo! when Google came along, you will also see that FMMA can be a sustainable competitive advantage over time, but that as a tool it is only as durable as the management team that wields it.  It is only an advantage, not a guarantee. 

In terms of modern examples of FMMA at work, take a look at the ecoupon business, where Groupon can I think fairly lay claim to FMMA status.  It is clearly the big dog in terms of resources (brand recognition and value, as well as capital and revenues), and if the ecoupon business model has legs, Groupon would have to be the favorite to emerge as the dominant player.  But the favorite in a race still has to run the race, and run it well.  Favorite status is not a sure thing (Forrest got there first with the most and still, occasionally, came up short of victory; ditto Secretariat, the greatest thoroughbred of all time, who in fact did lose a race once).

In sum, the so-called First Mover Advantage is, for starters, incomplete.  Being first is great, but the advantage goes to the entrepreneur that gets there first with the most.  It is also an advantage that can be sustained – or not, depending on how well it is employed over time.

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Posted by pajones1

The Vision Rule

August 11, 2011

By: Paul Jones

One of the more insidious clichés of the venture capital business is the so-called “golden rule,” to wit that “he who has the gold, rules.” Alas, it’s a rule that too many less experienced entrepreneurs think is, well, golden. It’s not.

The problem with the golden rule is that it is premised on the notion that start-up success is mostly a function of access to capital. Now, when you are sitting in the proverbial garage and running out of money to keep even the lights burning, it is, I suppose, understandable to think that capital is the one indispensable mediator of success. But that is the thinking of ordinary folk. Entrepreneurs are made of sterner stuff – or at least the ones who earn the sobriquet are. Because while capital may be a necessary part of entrepreneurial success, it is not sufficient. Far from it. Ultimately, capital is like fuel in a NASCAR race: something you have to have, and you have to manage carefully – but ultimately it’s the driver (the entrepreneur) and the team/car (assembled and empowered with the entrepreneur’s vision) that wins the race (that makes the business a success). It’s as much about vision – more really – than it is about gold.

Entrepreneurs – even in places where gold is scarce, like here in Wisconsin – must remember that as necessary as investors may be to accomplishing their business objectives, they, the entrepreneurs, are equally as necessary to the investors if they, the investors, expect to accomplish their investment objectives. Because there is another rule of startup success besides the golden rule; let’s call it the “vision” rule. He who has the compelling vision, rules – because without a compelling vision no amount of gold will deliver the goods for either the entrepreneur or her investors.

Now, the vision rule can be just as insidious as the golden rule if taken out of context. Then again, if a prospective investor wants to play that kind of game, well, what’s good for the goose is good for the gander. Smart entrepreneurs, though, and smart investors, don’t live in cliché land. When a prospective investor implies that without capital an entrepreneur’s vision is worth almost nothing, a smart entrepreneur doesn’t get defensive but rather parry’s with the equally valid (and equally limited) notion that without the entrepreneur’s vision the investor’s capital isn’t going to produce the kind of returns that the investor is looking for, either. Or, to put it another way, either party – the one with the vision as well as the one with the gold – can stop the game before or during the match by taking his ball and going home.

The entrepreneur who understands the vision rule should not abuse it – any more than the investor who understands the golden rule should abuse it. But when an investor does abuse the golden rule – i.e. when an investor argues that the entrepreneur’s vision is worth next to nothing without the investors gold – the entrepreneur should remind the investor (gently if possible, but more forcefully if necessary) that without the entrepreneur’s vision their would be nothing to invest in. In practical terms, when the investor tries to shift the ground of the valuation discussion to what the vision would be worth without the investor’s gold, the entrepreneur should counter that no, the debate is really about what the valuation is when the vision and the gold come together. If the investor won’t go there, well, that is a pretty good sign that the investor thinks too highly of himself, or too little of the entrepreneur – or, perhaps more likely, both.

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Venture Capital: Preliminary Questions for Entrepreneurs

August 8, 2011

 By: Paul Jones

The Venture Capital industry has been a critical component of the high impact business scene in the United States for fifty years.  It is hard to imagine a Silicon Valley anything like today’s without recognizing the critical role venture capital and venture capitalists have played in creating and sustaining it – “it” being an innovation engine of unmatched impact anywhere else in the world, and one that, gradually, is infiltrating other parts of the nation and globe.  And yet, many entrepreneurs are deeply suspicious of the industry and its practitioners.  Many entrepreneurs, including even a few who have, or at least seemed to have, benefited from working with venture capitalists, talk about the industry with terms like “vulture capital” and “vulture capitalist.”  What goes on here? 

As a serial venture-backed entrepreneur, venture capitalist and counsel to dozens of entrepreneurs and venture capitalists over a twenty-five year career in Silicon Valley, North Carolina and Wisconsin, my own take is that while there are surely bad actors in the venture capital community – as there are in any community, including the entrepreneurial community – most entrepreneurial animus for venture capitalists is based on misconceptions about the role and modus operandi of venture capital in the innovation process.  My own experience suggests that many (not all, but many) of the venture capital horror stories told by entrepreneurs involve deals that never should have been made at all: deals made by entrepreneurs who saw the capital but not the strings attached to it when they made their venture capital bargain.  In the interest of trying to stop some of those foredoomed venture capital deals that shouldn’t get done from getting done in the future, here are a few things entrepreneurs should think long and hard about before even considering looking for venture capital dollars for their deal. 

  1. Venture capital is expensive.  In fact, venture capital is the most expensive form of financing out there, at least on the right side of the law.  While an early stage venture capital investor may be seeking a “modest” 3x or 4x cash on cash return on their portfolio, the implications of that kind of portfolio return mean that they are looking for at least a 10x return on any given investment in that portfolio.  It takes a couple of such “home runs” to make up for the singles, doubles and strike outs that make up most of the typical venture capital portfolio, so every deal done has to have home run potential.  The implication of this, for entrepreneurs, is that the success bar is extremely high: that venture investors will hold them accountable for anything less than stellar results.  If you are not ready to be judged by those kinds of standards, don’t enter the arena.
  2. Venture capitalists are first and foremost accountable to their own investors, not themselves (and of course not their portfolio entrepreneurs).  They have legally binding fiduciary obligations to put the interests of their own investors ahead of their own interests and the interests of their portfolio companies and entrepreneurs.  Even the most entrepreneur-friendly venture capitalist, when push comes to shove, will look out for the interests of their own investors ahead of the interests of their portfolio entrepreneurs.  And they should: that is their job.
  3. Venture capitalists generally have egos on a par with entrepreneurs, which is to say that, pace entrepreneurs, they may be wrong a fair amount, but they are almost never in doubt.  If you are not comfortable working with folks who can be as stubborn and opinionated as you are, don’t expect a cozy relationship with your venture capital investors.
  4. Venture capitalists work for venture capital funds, and both venture capitalists and their funds are significantly influenced by the dynamics of their own career development path as well as their fund’s evolution – good or bad – over time.  Venture capitalists come and go – your great relationship with a venture fund can be recast overnight if your venture capitalist leaves the fund.  No matter how supportive and enthused your venture capitalist may be about your deal, if her venture capital fund has limited cash resources (and they all do) your ability to access those resources in a pinch is up to the fund’s management as a whole, not your particular venture professional (and, of course, at some point, there just isn’t any dry powder left for anyone). 
  5. Just about every venture capitalist believes – really – that they and their fund bring more than money to the table.  And many of them do.  Unless you agree, stay away.  Nothing can sour a venture capital relationship quite so fast as an entrepreneur who won’t listen respectively to, if not always take, advice from their venture capital investors.  If you want passive investors, don’t look for venture capital funding.
  6. Pretty much all venture capitalists have big egos (see above).  They all have strong and usually in some way unusual personalities (as do most serious entrepreneurs).  There are quiet, supportive types (well, a few) and there are folk like Don Valentine, a widely-respected dean of the industry who has been quoted over the years (without ever denying it, to my knowledge) as follows:  “I have never fired a CEO too early in my entire career.”  The point?  However good the fit might otherwise be with a venture capital fund, make sure you can get along and be productive working with the particular venture capitalist who will be working your deal.  (And, per 4 above, hope that particular venture capitalist stays with her fund and your deal for the long haul.) 

I am sure there are some entrepreneurs reading this who are wondering just why, in light of the above, anyone would want to work with venture capitalists.  If you are one of those, well, don’t; seek venture capital, that is.  Devise a bootstrapping financing plan, or, if that isn’t practical, think of an idea where that is practical, or find another direction to go with your career.  On the other hand, if you can, with your eyes really open to the above rules of the road, think of working with a venture capitalist as just another part of your challenge, something to be relished rather than feared, go for it.  But if you end up road kill, well, that happens.  Just about every ultimately successful entrepreneur makes big mistakes and has big failures.  Just ask Steve Jobs, he of the Newton PDA and NeXT Computer.

 

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Posted by pajones1

International Patent Protection

August 4, 2011

By: Ivan Kirchev

Startups, entrepreneurs, and small companies must try to protect their intellectual property rights both in theU.S.and overseas.  Although international patent prosecution can be a complex and costly process, companies should consider creating an international patent portfolio.  Having such patent portfolio will certainly make the company more attractive forU.S.and foreign investors.  If a company already has pending U.S. patent application(s), the company can seek protection of its inventions outside of the U.S. by filing foreign patent application(s).  Generally, there are two ways to pursue foreign patent protection. 

A company can file an application directly in each desired country or region (i.e., in Europe, Germany, China, etc.).  Most foreign patent applications can be filed based on an U.S. application.  As a general rule, these foreign applications must be filed within one year of the U.S. filing date in order to obtain the benefit of that U.S. filing date.  Cost of foreign filing depends widely on the country and includes filing costs and the corresponding patent prosecution fees of foreign associates handling the prosecution.  

Alternatively, a company can file an international Patent Cooperation Treaty (PCT) application within one year of the filing date of the U.S. application.  The PCT application provides, in essence, a placeholder and opportunity to file one international application and have the patentability of the claims examined under international standards.  Currently, the PCT includes 139 member states including most industrialized nations.  The applicant will receive a report regarding the patentability of the claims in about six months after filing.  Eventually, the applicant will have to choose specific countries in which it ultimately desires to obtain a patent.  The PCT is a patent “filing” system, not a patent “granting” system.  There is no “PCT patent.”  The applicant can start the application or “national phase” process in any particular country that is a member of the PCT right after filing the PCT.  Alternatively, the applicant can wait to receive an international search report and written opinion of patentability.  Filing through PCT, instead of directly in the member countries, allows an applicant to delay “national phase” filing in these countries up to 30 months from the U.S. filing date (31 months in some cases).  Generally, if company would like to have one or more patents in hand as soon as possible, it should start the national phase immediately after filing the PCT.  Alternatively, if a company would like to defer costs and see what the patentability report indicates, waiting is a reasonable course of action.

There are many benefits to filing a PCT application.  A PCT filing provides one application, in one language, filed with one Office that defers multiple foreign filings until entry into the national phase.  The PCT application permits last minute foreign filings and provides an international filing date.  The applicant can make amendments to an application that will be in effect in all designated elected states.  In addition, the applicant can better plan expenses for the national phase filings and thus can control its overall costs. 

On the other hand, at the time of filing the PCT application, the applicant may also want to file national applications in countries not included in the PCT, which is a relatively small number of countries.  Costs and fees for filing a PCT application are estimated around $3,000-$4,000.  Nationalizing the PCT application in the countries selected by the applicant adds additional costs which vary between the PCT member countries.  The highest filing cost is with the European Patent Office (around $9,000), but a European application will give the applicant the opportunity to select many countries inEurope.  Filing in other PCT countries may cost around $500-$700 per country (these are just filing costs).  Prosecution fees and maintenance fees add extra cost to the application.  Below is a link to a list of the counties participating in the PCT. 

http://www.uspto.gov/web/offices/pac/dapp/pctstate.html

Therefore, a company should determine its goals with respect to foreign patent protection and decide which of the above-identifies international filing options works best for its objectives and budget.

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Posted by itkirchev

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