By: Paul A. Jones
In a recent blog on Technori.com, Venture Best Co-chair, Paul Jones talks about Milestone Financing. Please see the link below to view the full article.
By: Paul A. Jones
In a recent blog on Technori.com, Venture Best Co-chair, Paul Jones talks about Milestone Financing. Please see the link below to view the full article.
By: Paul A. Jones
Having been around the high impact startup and venture capital business for almost 30 years, on both coasts and now here in Wisconsin, I’ve developed a pretty good set of rules of thumb. One of them is that while all kinds of folks like to think they can duplicate the success of venture-center accelerators like YCombinator, most of them – particularly in flyover country – can’t. The fact is, very few folks in the accelerator business have the skills, experience, networks and capital to even approach the value add proposition of a YCombinator.
Thus, a year or so back, when I first heard of the folks at gener8tor, then setting up shop in Milwaukee, I was more than a little skeptical. And when I met gener8tors first class, early in the process, my skepticism only grew.
Alas – well, actually, happily, as someone who continues to believe that Wisconsin can develop a self-sustaining high tech startup/venture capital community – when I saw that class at Launch Day 2012 I was, if not stunned, at least very surprised at what I saw and heard. Entrepreneurs that a couple of months earlier seemed more or less like clueless wannabes were now looking like credible go-getters with fundable business plans. Not surprisingly, most of them got funded, and several are making waves well beyond flyover country.
Now, on any given day, anything can happen. Just ask the Florida Gulf Coast University Men’s Basketball Team. Well, here we are in 2013 and … the folks at gener8tor have done it again, this time here in Madison. They sifted through 200 plus entrepreneur applicants, picked out six keepers, and in 12 weeks of intense counseling, mentoring, prodding, testing and pivoting, they are ready to launch 6 more promising high impact businesses into the economy. I know because as advisor to an angel fund, I had an opportunity to see the pre-Launch day pitches this week and, well, while I very much doubt all of these companies will hit home runs, I’d be surprised if they all don’t at least raise some serious capital and take a serious shot at success. Which is a lot more than I can say for most of the startup entrepreneurs/deals that come across my desk. If you don’t believe me, come to gener8tor’s Launch Day April 4 in Madison and see for yourself. For a free ticket, email firstname.lastname@example.org.
By: Paul A. Jones
In a recent blog on Technori.com, Venture Best Co-chair, Paul Jones talks about compensation for Directors at startup companies. Please see the link below to view the full article.
By: Paul A. Jones
In a recent blog on Technori.com, Venture Best Co-chair, Paul Jones talks about the four things to understand about venture capitalists. Please see the link below to view the full article.
By Paul A. Jones
On Tuesday, January 15, the Venture Capital practice group, Venture Best, invited Entrepreneur, Co-founder and President of Alithias Ross Bjella, to present a brief introduction and demonstration of his product to a number of Michael Best attorneys from various practice groups, specializations and locations. Alithias is a healthcare price and quality “look-up” tool that provides the information, incentives and analytics to help employees get the most value from their healthcare benefit. Unlike dial-up advocacy services, employees can quickly and privately shop for healthcare services. Alithias analyzes historical claims data to help employers modify plan design, wellness or incentive programs to encourage high value decisions. The package is based on a successful program that has kept healthcare insurance premium increases to less than 1/2 the national average for over 8 years.
In a follow up conversation with Bjella on the opportunity and materials, he mentioned, “As a start-up, the ability to access information and receive feedback is often more valuable than revenue. Entrepreneurs can’t be experts at everything so we rely on trusted advisors to fill in the knowledge gaps. The opportunity the Venture Best folks provided me, a luncheon presentation to select Michael Best attorneys working in the employment benefits space, was much appreciated. It was a great opportunity for me to receive feedback from experts in the field and spread the word to folks who work with the kinds of companies that Alithias targets every day. Michael Best’s proactive support of Alithias outside of the formal (e.g. billed) client relationship – by providing valuable insights and networking leads through events such as this – is something that continues to impress me about Venture Best and Michael Best’s “value added” approach to legal services.”
Bjella is the former President of DDN, a Menomonee Falls based outsourced business service company and a two time regional finalist in Ernst and Young’s Entrepreneur of the Year program. His operating team, Ojash Shrestha and Matt Olson, have many years’ experience in user interface design, database architecture and managing secure multi-relational databases. Alithias completed an initial angel funding round of $250,000 in 2011 and currently has a client list that includes Bemis, Sargento, Menasha and other well-known WI based companies.
Michael Best has served as Alithias’ legal counsel since its founding in late 2010.
We plan to conduct more of these lunches in the future. Please contact Paul Jones at 608.283.0125 or email@example.com or Kate Bechen at 414.225.4956 or firstname.lastname@example.org to express your interest or learn more.
In late 2012, Paul Jones, Co-Chair of Michael Best’s Venture Best team, spoke with Eric Wagner, a serial entrepreneur, regular blog contributor at Forbes.com, and founder of Mightywisemedia. The discussion focused on ideas that high impact entrepreneurs can use to attract venture capital dollars. Recently, Eric summarized the conversation and Paul’s ideas on his Forbes blog 12 Tips on Raising Venture Capital for Your Startup.
One of the more material, contentious and potentially confusing issues in negotiating venture capital term sheets is the structure of the so-called liquidation preference. Perhaps better thought of as the “exit preference,” this is the term that spells out how the proceeds from a sale of the business are divided between the common shareholders and the various investors holding shares of preferred stock. Since the vast majority of successful exits involve selling the company, the structure of the liquidation preference is a critical part of the investment terms.
There are two basic takes on liquidation preferences. One preferred by investors is called “participating preferred.” With participating preferred, when the business is sold the investors get their money back before any exit proceeds are distributed to the common shareholders. Next, over and above that “base preference” amount, the investors share the remaining proceeds pro rata with the common shareholders, assuming for such purposes that their preferred shares were converted into common shares the instant before the distribution to common shareholders. The other liquidation preference paradigm is simpler (and preferred by founders and other common shareholders, who generally characterize participating preferred as “double-dipping”). With so-called “non-participating” preferred, the investors holding preferred shares have to make a choice. Either they can get their money back via their base reference OR they can convert to common and share the entire proceeds pro rata with the other common shareholders. With non-participating preferred investors can’t “double dip.”
If you run the numbers, you will find that while the difference between so-called “participating preferred” and “non-participating preferred” impacts who gets what in every case where the proceeds available for distribution exceed the amount of the preferred’s base preference. The relative impact, that is, the impact when considered in terms of how much money the preferred and common shareholders ultimately get relative to each other, gets smaller as the difference between the amount available for distribution after payment of the base preferred preference gets bigger. As a practical matter, if a deal is a “home run” (say 10x or more return on the preferred investment price) only the true bean counter of an entrepreneur is going to lose much sleep over the “extra” return delivered to the preferred investors on account of their enjoying full participation.
So, investors are better off with participating preferred, while founders are better off if the investors get non-participating preferred. The differences in outcomes can be quite significant for both parties when the exit produces a modest win for the investors rather than a home run – which is the case in most positive exits. Not surprisingly, entrepreneurs and investors have looked for ways to compromise on the participating/non-participating term.
The most common compromise is capped participating preferred stock. With capped participating preferred the preferred has a choice but it is more complicated than the choice with non-participating preferred. Basically, with capped participating preferred, the choice is between participating but only until the agreed cap on participation is reached OR foregoing the base preference and share all the proceeds available at the exit with common shareholders as if the preferred was converted to common immediately prior to the distribution. For example, with a 3x cap, the preferred would choose to participate if the alternative (immediate conversion) would result in less than 3x the basic participation preference. By way of a simple example, if the preferred held one million shares for which it paid $1 per share (and ignoring any complicating factors such as unpaid cumulated dividends that add to the basic preference) and enjoyed a 3x participation cap, it would choose to convert only if by doing so it would receive as its pro rate distribution more than $3 million.
On a quick read, capped participating preferred seems pretty straight forward. Unfortunately the simplicity of this particular compromise comes at a price: it obscures some nuances of liquidation preference participation return caps that at least somewhat undermine their appeal. The first, and most obvious flaw, is that return caps do not effectively reflect a compromise between the preferred and common shareholders over the range of deal returns (the modest positive exit) where the difference in outcomes most acutely impacts the common shareholders. As previously noted, the impact of participation on the relative returns of preferred and common shareholders is larger when the deal return multiple is lower, and rapidly decreases in significance as the deal return multiple increases. So unless the return cap is very low, say 2-3x max, most of the “double dipping” advantages to the investors associated with participating preferred will still exist.
The second flaw is far less obvious, and is more or less important depending on how cynical the entrepreneur is about his/her investors.
Recall that with participating preferred, an investor’s share of exit proceeds consists of his/her base liquidation preference plus pro rata participation in any remaining proceeds. In this scenario – in effect a 1x cap on the liquidation preference – the investor, during the negotiation of an exit transaction, will always have an incentive to seek the highest exit price because the investor will get a portion of every additional dollar of exit proceeds, every dollar up to his/her base preference amount and a pro rata share of every dollar above the base amount.
But now let’s consider an exit cap of 3x. Assume also that the investor has a $1 million base liquidation preference, and that the investor and the entrepreneur each have a 50% share of the equity. Now let’s look at three exit scenarios: exit proceeds equal or less than $6 million, exit proceeds greater than $9 million, and exit proceeds between $3 million and up to $6 million.
In the first case, where the proceeds are less than or equal to $6 million, the investor will always take participation, as that choice will always deliver 50% or more of the proceeds to the investor; i.e. the investor will get at least his pro rata share (in fact at $6 million the investor will get exactly his pro rata share, $3 million, and at $6 million will get that $3 million plus his 50% pro rata share of the next $3 million, for a total of $4.5 million).
Now let’s assume the exit proceeds are greater than $9 million. The investor will always decline participation and convert, because his pro rata share of any amount over $9 million will always be more than $4.5 million – his pro rata share of the $9 million of exit proceeds.
Did you notice something here? In the case of $6 million of exit proceeds the investor will get $4.5 million by participating. In the case of $9 million of exit proceeds the investor will get $4.5 million whether he participates or simply takes his pro rata share. That leaves the case of exit proceeds between $6 million and $9 million, and if you run any number in that range you will see that the investor will prefer participation and in each case will end up with $4.5 million. Thus the investor will be indifferent between a deal that provides exit proceeds of anywhere between $6 million and $9 million because all of the proceeds between $6 million and $9 million would go to the entrepreneur. This “zone of indifference” means that in any exit negotiations the investor has no incentive to push the buyer to pay more than $6 million unless they think they can get the investor to pay more than $9 million. Indeed, once the investor perceives the company could fetch $6 million in an exit, there will be some temptation to sell right away as the next 50% of value building will all accrue to the common shareholders.
How important, from the entrepreneur’s perspective, is the zone of indifference implicit in any participating preferred with a cap scenario? That depends, as suggested earlier, on how big the likely zone of indifference is in the particular instance (a function of the size of the cap, the size of the base preference and the pro rata ownership of the investors), and how much faith the entrepreneur has that the investor will support an entrepreneur negotiating for a higher exit price when the likely higher price is still within the zone of indifference and thus all the benefits of the higher price accrue to the entrepreneur. Human nature being what it is… Well?
So, we end where we started. Yes, entrepreneurs and investors looking for a middle ground between participating and non-participating preferred stock can split the difference by settling on participation with a cap. But caveat emptor – or, more to the point, caveat entrepreneur. The benefits, to the entrepreneur, of the cap are not as appealing in practice as they are in theory.
For some time now, convertible debt has been the poison of choice for seed financings by angel investors. Basically, these deals involve the investor providing capital in exchange for a note that automatically converts into equity at a future financing round, usually either at a discount to the price of the round, or with the addition of a warrant “kicker” for the investor. The principal advantages of convertible debt in the seed financing context are (i) the ability to punt on valuation, thus avoiding a likely contentious and sometimes even deal killing negotiation, and (ii) it is, compared to a more traditional equity transaction, much simpler and cheaper to paper. (Click here for a more detailed review of convertible debt in the seed financing context).
While the convertible debt structure is well-established, and has generally served angels and entrepreneurs alike pretty well, it does have its problematic aspects. First, as much as both parties may think of a convertible note as in substance equity, it is in fact a debt instrument. It has to be carried on the startups books as debt, which in many cases might render the startup technically insolvent. In addition, convertible notes almost always include a drop dead date, typically 12-18 months out, after which the holder of the note can demand payment. If the entrepreneur is not in a position to make the payment they give the note holder enormous leverage. There is also the matter of interest rates and payments, which adds a wrinkle to the accounting and the valuation issues. Finally, for those angels who lie awake at night worried about legal issues, in most states these transaction require that the angel be a licensed lender (I am not aware of a lot of enforcement activity in this area).
Recently, Adam Ressi of TheFunded.com and the Founder Institute teamed up with the folks at Wilson, Sonsini to devise a more entrepreneur-friendly alternative to convertible debt – convertible equity. Essentially, convertible equity is functionally equivalent to, and shares the advantages of, convertible debt, except there is no debt (and thus no liability on the balance sheet; no repayment obligation and no default-related control issues; no interest rate negotiations or accruals; and no need for the angel to be a licensed lender). What’s not to like?
Now I confess, there is a part of me that is thinking “if it isn’t broke, it doesn’t need fixing” and that the convertible debt seed financing vehicle doesn’t strike me as particularly broken. On the other hand, at least from the entrepreneur’s perspective, convertible equity looks like a modestly better deal – albeit at some expense to the investor. It is too early to say if convertible equity will ultimately emerge as a winning alternative to convertible debt. Stay tuned….
Willie Sutton once famously quipped that the reason he robbed banks was “because that’s where the money is.” Wisconsin and other flyover country entrepreneurs can learn something from Willie’s thinking. When looking for risk capital, at least think about going where the money is. Which is to say, the west and east coast venture centers.
Count me as one of those folks who think that unless at least a few venture center investors start regularly plying their trade in Wisconsin, the state will have a hard time building a sustainable high impact entrepreneurship and investing sector. Getting there, however, will take a long, long time if our entrepreneurs and regional investors passively wait to be discovered by the folks on the coasts. Rather, our entrepreneurs need to be aggressively reaching out to the major venture centers. There’s a lot of noise in the Silicon Valley venture capital business: if you don’t go there and make some of your own, no one is likely to hear you from 2,000 miles away.
Based on some recent “real world” case studies, it is increasingly apparent that while our state’s supply of “prime-time ready” deals is still small, such deals do in fact exist. Several Wisconsin entrepreneurs have, in recent months, found that quite a few of the established venture investors in places like Silicon Valley are more than willing to listen attentively to their stories. Even when these funds have not put term sheets on the table (and some have), they have shared knowledge and experience with our entrepreneurs – and generated excitement among some of our regional investors that accelerated closings and enhanced valuations for some of our homegrown entrepreneurs, and established relationships that could be very profitable at the next round.
Wisconsin’s entrepreneurial community may be younger and less experienced in the ways of the venture capital game than their coastal counterparts, but there are an increasing number of exceptions to the rule. Those folks need to start looking beyond Wisconsin and the Upper Midwest for funding and do something about it in terms of taking their stories to the major venture centers. That’s where the money is.
The “lean startup model” is all the rage in the entrepreneurial world these days, and it should be – for the right kind of startups. That is, startups that can realistically talk about delivering the model’s “minimum viable product” (MVP) to market for very little money (tens of thousands of dollars) in very little time (a few weeks or months). For example, web app startups and such. Alas, if you happen to be an entrepreneur in the life sciences world, chances are your MVP will take a lot more capital (seven or even eight figures) and a lot more time (a few years, or even a decade) to deliver. The lean startup model, then, really doesn’t have much to teach life sciences entrepreneurs.
Or, maybe it does.
As someone who has been an IT and life sciences entrepreneur, and an angel and venture investor in IT and life sciences startups, my initial reaction (putting my life sciences hat on) to the lean startup model and its MVP was “wouldn’t it be nice if you could launch a minimally viable new drug in 90 days with $50,000?” It would be, but trust me, you can’t.
Still, I have been working with a group of mostly life sciences entrepreneurs in the Innovate program in the DC area sponsored by the National Science Foundation, Johns Hopkins University, the University of Maryland and various state and local economic development organizations. Most of the entrepreneurs in the Innovate program are focused on businesses opportunities that will ultimately take at least several years and several million dollars to get to an MVP. Watching some of these entrepreneurs give one minute pitches last week, it occurred to me that while they could hardly expect to raise enough capital, out of the gate, to get to their MVP, they still needed to think in MVP-like terms. More specifically, they needed to think in terms of their “minimum viable milestone” (MVM).
The idea behind the MVP is to get something in the hands of customers as fast and cheaply as possible, so that you can (i) quickly establish the core of the value proposition by getting some traction with real consumers, and (ii) get feedback from real consumers as fast as possible so you can rapidly improve the value proposition. As noted, those goals, in the life sciences environment, are likely to take millions of dollars and several years. But the lean startup paradigm can be generalized to fit a larger range of startups by recasting it as “get somewhere really important as fast as possible with the least amount of capital” – which is to say that whatever the industry the entrepreneur should focus on getting to MVM as fast, and as cheaply, as possible.
In some ways, the MVM idea may seem obvious. Obvious, in the same sense as the MVP idea is for a startup web app company. But thinking in MVM terms is not obvious to many entrepreneurs – particularly life sciences entrepreneurs. Many life sciences entrepreneurs come from an academic environment. In the academic world, the “progress paradigm” is quite the opposite of the MVP: Meet the LPU, or “least publishable unit.” Advancing your career in the academic environment is largely based on how many papers you publish in peer-reviewed journals. A good academic researcher thus will look at a problem and think “how many papers can I publish on the road to solving this problem?” not “what is the quickest, cheapest way to solve this problem?” And that kind of thinking, in the startup context, is a recipe for disaster.
Therefore, the lean startup model has something to teach all entrepreneurs. For those with opportunities where being lean means focusing on the MVP, well, aren’t they lucky. But for entrepreneurs in just about any space, the more general MVM is almost always the best place to start. When you pitch your startup investors for that early money, keep the focus on what it will take (in time and money) to get to the first milestone that will substantially improve your long-term chances for success. Keep the focus on the MVM.