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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Commercial Biopharma in Wisconsin: What Next?

August 3, 2011

By: Paul Jones

The University of Wisconsin – Madison, is one of the country’s leading centers of public biopharmaceutical research, and the campus has spawned dozens of spinout companies based on University research. For this, the citizens of Wisconsin should be grateful; and, even more so, hopeful. Grateful because a foundation capable of supporting future growth is in place; hopeful because given the right conditions that growth could, over the next five years, support the emergence of the Madison area as one of the nation’s top five centers of commercial life sciences investment, and indirectly the emergence of Wisconsin as an important mid-continent oasis for venture capital investors that today think of the state as flyover country.

The major progress to date is reflected in the dozens of Madison area life sciences companies, including biopharma companies, with important ties to UW-Madison research. While not large by national standards (UC-San Diego – good school, but hardly a match for Madison – has spawned a couple of hundred life sciences companies) it is a big enough number to establish that the University is technically capable of, and, as important, culturally willing to enable, the kind of private/public collaborations that are critical to realizing the “real world” potential of the University’s basic research.

So, the question is no longer can Wisconsin play in the biopharma major leagues, but can it compete for championships. Can Wisconsin, instead of being known for a handful of companies worthy of acquisition by larger, better funded national firms with roots outside the state, become a major center of large, well-funded companies acquiring promising competitors and moving their operations to Wisconsin. The answer is, in my opinion, yes – if we can take two big steps. The ultimate step is becoming tightly integrated into the major venture capital markets, particularly on the two coasts. The penultimate step is moving our biopharma university spinouts from founder/scientist-managed to professionally managed earlier in their development.

We need stronger ties to the major venture centers, particularly on the coasts, because that is where the majority of biopharma venture and other risk capital money is, in terms of quality as well as quantity. That is critical because compared to just about every other tech-driven sector, what sets biopharma company-building apart is the vastly more time and money it takes to build a profitable business. You simply can’t get a major biopharma company off the ground with a succession of six and low seven figure investments and SBIR grants. At best you will get to the table too late with too little – and create something for larger, better funded firms to snap up. Unfortunately, multiple high seven and eight figure risk capital investments are simply beyond the capacity of Wisconsin’s limited venture capital base; even more so if you limit the field to firms with nationally recognized life sciences bona fides.

So, how do we get the major biopharma venture capitalists on the two coasts to Madison on a regular basis? Not now and then, but as a regular stop where they make regular investments?

Having spoken with some; having worked on the west coast for life sciences companies and their investors; and having seen money center biopharma investors warm to the Research Triangle life sciences market over the period from roughly 1995 to 2005, I think the answer is professional management. Biopharma and other life science spinouts from places like UC San Diego – at least those that in fact receive substantial capital from the most highly-regarded life sciences venture investors – tend to share one key characteristic besides compelling science: experienced professional management. I believe that if our most compelling young biopharma and other capital and time intensive life sciences companies could match management resumes with their comparable counterparts on the coasts, our companies would, in short order, find themselves with comparable balance sheets as well.

Why is professional management so important in the biopharma space? Several reasons. Foremost among them is that building a major biopharma business not only takes more capital and time then building, for example, a software company, it is just plain more complex. The science is more complex, the regulatory environment is more complex, the market is more complex, and the business/financial models are more complex. The bottom line is that venture investors, who in almost every case put the quality of the management team ahead of other factors on their investment checklists, do so even more regularly when they evaluate biopharma and other complex capital and time intense life sciences investment proposals.

Why don’t our management teams match up well with west coast management teams? Two factors jump out. First, our founders (mostly university professors) have less experience (indirect as well as direct) than their counterparts on the coasts with the company building process. These are incredibly bright folks with incredible amounts of energy and, no offense intended, they all too often underestimate the time, energy and skill it takes to build a world class biopharma company. As a result, they are often reluctant to transfer management of their companies to “the suits” nearly as early in the process as they should. We have to change that mentality if we want to generate sustained serious investments from serious life sciences venture capital investors.

Another reason we don’t have a deep pool of experienced company builders managing our biopharma spinouts is that it is hard to attract them here. No, I am not talking about the climate, though I am sure weather is not a net plus for us. Rather, I am talking about the career risks an experienced biopharma professional takes when they move to what is, for now, a minor league city in terms of “big time” (read “big money”) emerging biopharma companies. The kind of manager we are talking about wants to know that if the deal they are working on now doesn’t work out – or even if/when it does – they won’t have to relocate (again) to find their next opportunity.

To some extent there is not a lot we can do, locally, to change the metrics of the “what will I do next problem.” But there are a few things that would help. One is changing the dominant “I can do this myself” culture common among the area’s founders. Another is making sure that the great science we have here in Madison is more visible in the business community on the coasts. I very much doubt, for example, that the typical life sciences manager on the west coast realizes that UW-Madison is a top-3 recipient of NIH funding.

UW-Madison, and the region, has made enormous progress over the last dozen years in demonstrating both the ability and willingness to work with the private sector to commercialize the University’s extraordinary research. If we can take the next big step – recognizing the need for and successfully competing for experienced professional biopharma managers – we will, I think, rapidly find ourselves among the nation’s leading centers of biopharma venture capital investment. And, once the venture people are here, they will – probably to their surprise – find that we have lots of other great technologies ripe for venture investment as well, all around the state.

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Thinking About the Next Round

July 28, 2011

By: Paul Jones

For many less experienced entrepreneurs, the search for that first round of outside capital is so all-consuming and stressful that it is hard for them to imagine that a subsequent capital campaign could be any more difficult.  More experienced entrepreneurs know better.  Now, a hot company in a hot financing environment may indeed find existing and prospective new investors tripping over themselves to provide capital at outrageous valuations.  Just ask Facebook.  Far more typical, however, is the company that is more (or less) on plan, but running out of cash and confronted with a soft risk capital market.  For entrepreneurs in that scenario, getting the next round done can make getting the first round closed look like a relative cakewalk.  This post explores how, for the “it’s not going so good” to the “it’s going fine, but not great” entrepreneur, the second (and possibly third and ..,) round financing challenge shapes up from a negotiations perspective.

The first thing to know about follow on financings is that there are more people at the table than there were in the first round.  The relevant players in the first round are generally limited to the founders and the first round investors (usually represented by a lead investor).  When the second round comes along, however, there are three key players – the founders, the new investors and the original investors.  While it may seem as if the original investors “made their deal” when they did the first round and now just have to live with that deal, in fact they did not so much make a deal when they signed on to round one as put a stake in the ground.  A stake that includes a long list of rights, almost always including the ability to block a future round of financing that gives a new set of investors any priorities over the earlier investors – including at least some priorities which just about every credible new investor will insist on.  The bottom line: you probably can’t make a deal with new investors without the cooperation of the prior investors – and the new investors are often going to ask the prior investors to revise, to their detriment, some of the rights and privileges they fought so hard for at the first round negotiation.

And this is where it gets tricky for a lot of entrepreneurs – and even some less experienced first round investors.  Because while de jure (in law) the first round of investors likely have a veto over any financing that puts a new investor ahead of them in terms of rights and privileges, de facto (in fact) that veto is not quite as big a stick as it first appears.  Unless the original investors are able (and willing) to provide needed funding on their own, at terms that reflect fair value (i.e. that do not attract lots of third party interest), they will want at least some new deal to get done rather than see the company run out of cash.  It can be as if they have a big stick, in the form of protective rights built into the original financing terms, but lack the strength to wield it with maximum effect.

In practice, the position of the prior investors can be further complicated by differences of opinion within their own ranks.  While as a group the original investors were probably on pretty much the same page when they made the initial investment, the chances are pretty good that over time their attitudes towards the company have changed, either based on their analysis of the company’s prospects or for internal fund reasons (e.g. dwindling capital reserves).  While the lead investor from the earlier round is the obvious candidate to manage any such fracturing of opinions or capabilities, the lead could be one of the investors with a change of perspective.  Or the lead may see the diverging of interests/capabilities among the original investors as an opportunity to gain advantage over one or more of the other original investors.  The complexities can be maddening for the entrepreneur, as the task of raising needed new funds becomes, in large part, the task of making the old investors happy without turning off the new investors or – and this does happen – taking the hit himself to bridge any gaps between the two investor groups.

None of this is to say that a modestly down, flat or modestly up round has to be a trial by fire.  If the company has maintained a good working relationship with its early investors, and approaches them in a thoughtful (but not philanthropic) frame of mind, with a good appreciation for the practical realities of the bargaining powers of the various parties, a good deal for all parties can often be done with – well, realistically, let’s say about the same level of stress as a typical first round.

As noted, hot companies in hot markets often find the experience of closing a follow on round more exciting than stressful.  But for the rest, which is to say for most entrepreneurs, the best way to think of the first round, once it is in the books, is in terms of Finance 101 – a good introduction to the material, and a fine jumping off point for Finance 201.

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Pay to Play: Its About Breakfast

July 27, 2011

By: Paul Jones

Among the many variously simple and arcane provisions of venture capital term sheets, one of the more mysterious to many less experienced entrepreneurs and investors is the so-called “Pay to Play” provision.  The mechanics of Pay to Play are reasonably straight forward: if, in a subsequent down round financing after a round where a Pay to Play provision was installed, an investor in the earlier round refuses to participate in the new round (usually to the full extent of the investor’s pro rata participation in the earlier round), that investor will lose various of their special rights and privileges acquired in the earlier round of financing.  So, for example, an investor subject to a Pay to Play provision that refuses to take its pro rata share in a subsequent round would typically lose, going forward, its anti-dilution price protection and future round participation rights.

If the mechanics are reasonably clear, it is often less clear who the a priori winners and losers are.  Who, initially, wants to see a Pay to Play provision on the term sheet, and why?  And who is likely to resist a Pay to Play provision?

In terms of a first order analysis, Pay to Play is an intra-investor issue.  Typically, one or more investors favor the Pay to Play (lets call them the Pigs, in that, as pigs regard breakfast, these investors consider themselves fully committed to the investment) and the other investors the Chickens (in that they, like the chickens that provide the breakfast eggs, are interested in the proceeedings, but perhaps not really committed).  The Pigs are motivated by a concern (just how much of a concern will be revealed by how hard they fight for the Pay to Play provision) that if the company for some reason needs more money at a lower price in the future the Chickens will either not have any more eggs to contribute (one possibility) or will for some reason refuse to provide any more eggs.  Pay to Play, then, is a mechanism for the Pigs to say to the Chickens “when we say we are in this together, for better or worse, we really mean it.”

Now, this analysis is fine so far as it goes, and many entrepreneurs assume, based on this line of thinking, that they, as entrepreneurs, don’t really have anything at stake in the Pay to Play negotiation.  Which is a mistake.  Because while the implementation of a Pay to Play provision in a down round primarily pits Pigs against Chickens, the outcome of the dispute can have a big impact on what served at breakfast – which is to say whether and how the portfolio company is financed.  Look at it this way: a Pay to Play provision encourages current investors to participate in future down rounds, which is always (off hand, I can’t think of an exception) a good thing for the company.  And that is true even where, a priori (i.e. in the round where the Pay to Play is or is not imposed) the investors are all Pigs (or all Chickens, for that matter).

Conclusion?  While Pay to Play provisions may seem, at first blush, like something an investor syndicate can solve internally, in fact, Pay to Play is something entrepreneurs should be concerned with from the get go.  So, if as an entrepreneur your prospective investors offer a term sheet without a Pay to Play provision, my advice to you is to ask for one.  Depending on the broader context of the deal, you might decide to fight hard for it, or just use it as a bargaining chip.  But it has real value – both to give you a sense of what investor attitudes are to future rounds, and to have in your back pocket in the eventuality of a future down round – and thus should be on the table .

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Who Do Directors Represent?

June 15, 2011

By: Paul Jones

In companies with venture capital financing, the venture investors usually have a right to designate one or more directors. Indeed it is not uncommon, when companies have gone through multiple rounds of venture financing, to see boards where a majority of the directors are elected by the venture capital investors.

Many entrepreneurs, and even a few VCs, assume that “VC Directors” represent the interests of the venture capitalists who elected them. An understandable assumption, perhaps, but in fact that is not the case. All directors, no matter who elected them, are legally obligated to represent the interests of all of the equity owners of the company. (In fact, when companies are in severe financial distress, directors can find that their fiduciary obligations extend to creditors as well, but I’ll leave that for another time.) By way of analogy, just as the President of the United States represents all American citizens – those who voted for him as well as those who voted against him; indeed, those who did not or could not vote at all – a director of a company represents all of the owners of the company.

Most of the time, this legal principle has little practical import. Directors elected by the venture capital shareholders will tend to see issues brought to the board the way the people who elected them view those issues: presumably, that was why they were elected. Ditto, of course, for directors elected by common shareholders. But while there is nothing inherently wrong with that there is more to the story. Directors can take many actions the effect of which is to favor one group of shareholders over another. But a director who takes an action the purpose of which is to favor one group of shareholders over another, she is treading on dangerous ground.

Let’s look at an example and see how this plays out. Newco has gone through a round of venture financing, and Jane Doe, a general partner of the lead investor, Acme Ventures, represents the venture investors on the Newco board of directors. Newco is running low on cash, and Beta Ventures has offered to lead a new round of financing at $2.00 per share, a healthy premium over the previous financing. Director Doe votes against taking Beta’s offer, and, the following week, Newco’s board of directors, at director Doe’s suggestion, accepts an offer at $1.00 per share from Acme Ventures. Has director Doe done anything unlawful?

Well, in this case, the facts provide a lot of smoke, but do not go far enough to say, with certainty, that director Doe has done anything wrong. What we don’t know, on these facts, is why director Doe opposed the Beta Ventures offer. If, in fact, Doe thought the Beta offer was the “best offer” for the collective owners of Newco but voted against it with the purpose of forcing Newco to take a less attractive offer that favored the existing investors, Doe’s action would have been, well, actionable. On the other hand, if Doe, even knowing that turning down Beta’s $2.00/share proposal would result in Acme being able to do the deal at $1.00, had a good faith reason to believe that Beta’s offer was not, considering all terms of the offer, not just price, not the best deal for the company’s collective owners, Doe’s action would not be actionable.

None of this means that “who controls the board” is not an important variable for founders and investors alike. In most situations, the policy differences between directors elected by one group of shareholders and those represented by another group of shareholders are not going to rise to the level of compromising the fiduciary position of a director. Board control does matter. But at crunch time, when decisions are being made that will impact different ownership groups differently, every director should remember that her actions should reflect her view of what is best for the collective owners of the company, and not for any subgroup that elected her.

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Entrepreneurs, Investors and Board Meetings: What’s the Right Balance for Start-Up Companies?

June 7, 2011

By Paul A. Jones

Meetings are seldom fun, and board meetings are no exception. Moreover, meetings have a mostly deserved reputation for being unproductive wastes of time and talent. Still, some meetings – including board meetings – can’t be avoided, even by the most social-network enabled start-up entrepreneurs and their investors. So, given that board meetings are going to be with us whether we like them or not, let’s look today at the question of how often should you have them. I’ll talk about board meeting preparation and content in a later post.

While generalizations in this area can be problematic, my own view – based on having been both an entrepreneur and an investor in start-up technology businesses, as well as a counselor to such entrepreneurs and investors – is that most early-stage, tech-driven business should, at least for the first year post-funding, hold regular board meetings on a monthly basis, and that board members within a couple of hours drive time to the company should make every effort to attend in person.

Now, monthly meetings may seem like overkill, particularly if, like me, you dread attending formal meetings, and think of the start-ups anti-meeting culture as one of the things that give entrepreneurial firms a leg up on their more established and bureaucratic companies (most of which hold board meetings no more often than quarterly, or maybe bi-monthly). So, what gives? Why should entrepreneurs who are rightly skeptical of meetings generally want to have more board meetings than their more established competitors?

Several things come to mind. One is the fast-pace of start-up living. Start-ups can – and do – move faster than more established firms. Internal developments, product development, for example, is less predictable in terms of both substance and timing. And even if the external market doesn’t change faster for the start-up than for the more established company, the impact of those changes is often greater on the start-up, and beyond that start-ups are usually on a steeper market knowledge learning curve than the more established players. In short, time is even more of the essence for start-up than for more established companies, and that is one reason start-up boards should as a rule meet more often than boards of later stage companies.

Another reason start-ups should meet more often has to do with the expectations of inside and outside directors in terms of the role of the board and, most importantly, the value add expectations for outside directors and the need for time establishing good working relationships among directors, particularly between the insiders and the outsiders on the board. As noted above, things tend to move faster in the start-up world. Further, important strategic and significant operational issues tend to come up more often. And, finally, even if the financing dance went well, it is likely that it left the entrepreneur and investor(s) a little unsure about each other and, in any case, a bit up in the air in terms of what to expect from each other, in terms of information sharing and value add abilities and expectations. More regular meetings, particularly in the first year or so post-funding, can help address both of those challenges, and in the process foster better intra-board relationships and trust, as well maximize the value add of outside directors.

Finally, more regular board meetings can help a company establish and institutionalize more efficient and productive communications channels among inside and outside directors. The process of preparing for board meetings on a more regular basis – a sometimes frustrating process for senior managers with what seem like obviously more important ways to invest their time – can itself help both inside and outside directors “find their way” in terms of the appropriate timing and sharing of information about the company and it’s business and technology environment. Over time, as intra-board communications become both more routine and less formal, the regular board meeting schedule can be cut back.

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Valuation of the Company vs. Valuation of the Stock: A Venture Capital Paradox

June 3, 2011

By: Paul Jones

One of the first things entrepreneurs learn about venture capital speak is the significance and difference between pre-money valuation and post-money valuation. These are the terms that VCs use when talking about how much a company is worth before and after a round of financing. While investors in public companies tend to think of valuation in terms of how much one share of stock costs, VCs tend to think of valuation in terms of what percentage of the total ownership of the company they can buy for how much capital. So, for example, if a VC buys 1/3 of the ownership of Newco for $1.0 million, the “post-money” valuation is 3 * $1 million = $3 million and the “pre-money” valuation is $3 million – $1 million = $2 million. If say $2 million bought ¼ of the company the post would be $8 million and the pre would be $6 million.

Another thing entrepreneurs learn pretty early in the VC courtship ritual is that VCs typically get some form of “convertible preferred stock” in exchange for their capital. In the most general of terms, “Convertible Preferred” is a kind of stock that (i) has some extra rights that make it “better” than common (for example, liquidation and dividend preferences, the ability to prevent Newco from doing certain fundamental things like selling the company, etc.) and (ii) is optionally convertible into common stock by the holder at pretty much any time, and can be automatically converted in some instances (typically in connection with an exit transaction where the company is sold or completes an initial public offering at a sufficiently high price). Most often, the conversion rate is 1 to 1: that is, one share of Convertible Preferred converts in to 1 share of common. (The rate can be more or less than that, and can change over time, but neither of those facts changes the fundamentals of the analysis in this blog.)

Alas, these two concepts – pre/post-money valuation and Convertible Preferred – combine to create what looks like a valuation paradox. Let’s consider our $1 million for 1/3 ownership investment. And just to make the math simple, let’s say that the investor bought 1 million shares of Convertible Preferred for $1 each with a 1 to 1 conversion ratio, and the founders own all 2 million shares of common stock. In this situation, the post money is $3 million, right? And the 1 million preferred shares are worth $1 million, right? (Right in both cases.) So the 2 million shares of common stock must be worth $2 million, right? And each of the 2 million common shares must be worth $1, right?

Actually, in both the later cases, no. The common is not worth $1 share – how could it be worth as much per share as the Convertible Preferred, which can be converted to common at any time and has a bunch of special rights that add more value to it? If not a problem, we seem to have at least a paradox.

What is going on here? How can both the pre/post money valuation formula work AND at the same time the Convertible Preferred and Common stock have different values? Let’s try and hash that out, starting with the difference in value between the Convertible Preferred and the Common stock. As to the Convertible Preferred, the price, when it is purchased by a third party investor in an arms length transaction (in this case $1) is, by definition, the fair market value of the Convertible Preferred. Which means that the value of a Common share, at the same time, must, given that it lacks various valuable features of the Convertible Preferred, be worth something less than $1. How much less? Well, that depends. Since no one – or at least no third party in an arms length transaction is buying any at the time – it depends on what the Board of Directors, in good faith, determines it is as, for example, when it issues an option to buy such shares to an employee at what the Board says is the then fair market value of a Common share of stock.

Ok, at this point we know that a Common share is worth less than a Convertible Preferred share, and that the fair market value of the Common share is what the Board says it is. How should the Board determine the fair market value of a Common share?

In theory, the answer is simple; in practice, not so much. In theory, the board should (and any good board resolution purporting to establish the fair market value of a Common share will) “consider all relevant factors” to conclude that such value is less than the $1 value of the Convertible Preferred and more than $0. In fact, most boards will want to set a low value on the Common (to make equity incentive shares cheaper for employees and others getting shares of options on shares as an incentive to make the company succeed), but not so low as to attract the attention of the IRS, which is anxious to tax people who acquire assets, including stock, for less than it is worth.

In practice, there are some informal rules of thumb that tend to apply to very young and immature companies, and some explicit IRS/SEC rules that come into play for more mature companies. So, for example, a brand new startup like Newco might reasonably conclude that the value of a Common share was 1/5 the value of a Convertible Preferred share – which is to say the Common share has a fair market value of $0.20. No legal opinion is expressed here, but trust me: lots of companies have said as much without incurring the wrath of the IRS.

Ok, let’s go with $0.20. What, then, is the value of all of the stock – which is to say the value of the company? Well, there are 1 million shares of Convertible Preferred worth $1 per share, which is $1 million of value. And there are 2 million shares of Common worth $0.20 per share, which is $400,000 of value. So the total value of all the shares is … $1.4 million. Which is to say less than ½ of the post-money valuation of the company! Houston, we have a problem.

Or do we? Ok, there is a seeming paradox, but is there really a problem? I don’t think so. Because while the fair market value of the common might, at some level, seem like a more or less arbitrary determination of the Board of Directors, in fact it has to be something less than $1 in the example. And if it is anything less than $1 we will arrive at a total value of all equity that is less than the post-money valuation calculated by the VCs (and typically accepted, in normal conversation, at least, by the management/founders of Newco). The problem – perhaps a better word is artifact – is with the pre/post money concept.

And this is it. Buried in the pre/post money calculation is a very important assumption; namely that the VC post-money calculation assumes that the company will have a favorable – e.g. north of $1 per share (and probably at least 3x or more of $1 per share) – exit price when the company is sold or goes public. In which case all of the Convertible Preferred will convert into Common – and suddenly the assumption that they are worth the same amount … works.

It’s not elegant. It’s more than a little arbitrary and capricious. But it (more or less) works.

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Posted by pajones1

Compensation for Directors of Startups

June 2, 2011

By: Paul Jones

One issue that comes up fairly early for most start-ups – certainly by the time of the first outside funding if not before – is how members of the Board of Directors should be compensated. Every situation is unique, but what follows is my take on the generic question.

As a preliminary matter, Directors can fall into several categories, and compensation is most often tied to those categories. Inside directors include the founders and management team. Investor Directors are those who are associated with, or themselves are, material third party investors. The classic example is a director who is appointed by and affiliated with a venture capital investor or angel investor group. A significant “lone wolf” angel investor would also fit here (more on that later). Finally, everyone else – typically people who bring industry expertise or contacts, or are mentors for the management team – is pooled together as Independent Directors. Independent Directors may have made small investments in the business, but are not significant in terms of their capital contribution.

Ok, what do all these folks get for their Board service?

Let’s start with the easy ones. Insiders typically get nothing for their service on the Board. These folks, being founders or members of the management team, are already well compensated for their service. Being on the Board is a reward (of sorts) in itself, and simply goes with the territory.

Investor Directors are more or less in the same boat. They are by definition material investors (or represent material investors) in the business and serving on Boards of portfolio companies is part of their job, just as part of the CEO’s job typically includes serving on the Board. If the investment does well, they will be amply rewarded by the people or fund they represent.

That leaves the Independent Director. The easier cases, here, are the truly independent director who is not affiliated with or representing an investor group and has made no independent investment, or has made only a token independent investment. Depending on level of experience and perceived value add, these folks may get something in the twenty-five to two hundred basis points range – something between 0.25% and 2.0% of the equity, typically vesting over two years. Beyond expense reimbursement, you should not have to pay these folks any cash compensation (beyond expenses), at least not until the company is actually generating cash in the business.

While these are good general rules, there are some common situations that sometimes don’t fit within them so easily – or at least the Director in question might think they don’t. The first of these situations, and the easiest to deal with, is the “superstar” director. For example, if Steve Jobs tells you that he is really excited about your iPhone applications company and would be willing to serve on your board of directors for a hefty chunk of equity, don’t feel bound to tell him that the most you can offer is two hundred basis points.

In my experience the most contentious Board compensation issues arise when a Director affiliated with a fund of some sort, typically a group of angels, wants an independent equity stake for serving as a Director. My own view, and I think the majority view in the major venture capital centers, is that these folks are in the Investor Director camp and should not “double dip” in terms of their equity compensation. If the angel group they are affiliated with wants to provide them with some deal specific incentive compensation they should do it by carving out a piece of the equity they purchased. That said, in tight capital markets; in places (like Wisconsin) with limited risk capital access in even good times; or in situations where the capital-affiliated director is in fact going to be an active contributor above and beyond the level expected of the typical outside director, this is an area where entrepreneurs are often either (i) forced to cave on the principles of the matter to get a deal done in the first two cases, or simply recognize the realities of the situation in the later instance. If the “independent investor” insists on compensation, try to keep it under 100 basis points.

Board compensation for start-up companies is as much art as science, and the above guidelines are just the thoughts – albeit based on 25 years in and around these deals with multiple experiences as an Inside, Independent and Investor Director – of one man. But as a starting point, I think they will serve startup companies well.

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Posted by pajones1

I Knew the Dot Com Bubble ….

May 26, 2011

By: Paul Jones

… and this isn’t it.

Seriously, one hot company (LinkedIn) doubles in price on IPO day, several dozen venture backed companies have gone public as May draws to a close, and the Chicken Littles of the investing world are issuing Bubble Warnings. Hello. I was around for the real Bubble. It happened after a year where not one but well over 100 hot companies at least doubled their price on IPO day. It was a year when almost 550 companies went public. It was a year where “business” models were denominated in eyeballs, not dollars. And it was an event where entire markets crashed, not a collection of highfliers.

I confess, I do not get LinkedIn’s valuation. And I expect that, over the coming months, there are going to be some more things I don’t understand. But so far, at least, these are things that (i) I don’t understand but can at least imagine without blushing; and (ii) are pretty well confined to a rather narrow sector of the market. As to my imagination, if you don’t see the difference between a LinkedIn and, say, a Boo.com or Pets.com, well, try harder. As to the breadth of the rally cum bubble, back then it was not just all of the Dotcom world but pretty much all of the tech world. Today, the “what are they smoking” valuations are pretty much limited to the social network sector (though there are, of course, some high fliers like Apple in a few other sectors).

In short, my guess is some people are going to get burned by some of today’s hot deals. But I’ll be surprised if there are any mass cremations.

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Posted by pajones1

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