Monday, April 21, 2008

When to take a smaller piece of a larger pie and Femtocells ... a new wave?

Femtocells have become a hot topic over the past year with the competing forces of cable companies, Internet companies, and now cellular carriers trying to own the home portal. Google’s recent investment in a femto maker stimulated a lot of questions around the space. Femtocells give you cellular coverage at home where most of us don’t get it (see the carrier it defers infrastructure spend for better connectivity and higher speed, and offers a home portal where they can sell higher value services. Since VOIP is starting to eat their voice revenue, it’s a good defensive move.

I’ve looked at a few of these companies, at various levels in the value chain. I am told by many local VCs that this is not a market yet, and that everyone who makes a part of a femtocell is expecting to win big, but only the femto makers or the carriers will really win. Other VCs have told me that the component makers will be the winners, which is hard for me to believe despite the JDSU analogy (remember when all they made was HeNe lasers).

A critical problem in femto is network timing and synchronization, and there are three quite different ways to solve this problem. I have seen three really good companies in the component end of this space, but I think two of them need to be put together. We really wanted to invest in this combination and build a killer femto play.

One of the companies has been around for a long time and tried several incarnations of its technology in various markets before femto came along. The VCs had some investment fatigue and we thought a deal could be struck to get the company better capitalized and fund either a put together or a strong standalone company. So history is a good thing, but if a deal has been around a long time, it can get difficult to deal with the history. Expectations get low with fatigue, but when there is a ray of hope the pendulum can swing heavily the other way and expectations get reset to much higher levels than perhaps they should. With history, and many rounds of financing to re-task a company, valuations become a little irrelevant; as a practical matter there is only so much of the company that the VCs can own--in non US deals these numbers get frighteningly high: 80-90%. And as an entrepreneur I wonder why the teams stay in those companies?

In practice what usually happens is the ESOP gets reset, so that new team members can be attracted and old ones retained, and the company is recapitalized for the new plan. With history, founders and original investors feel that much value has been built and valuations should be high, but new investors may look at the deal and feel that since the company has a new plan it’s a new A-round--consequently attracting a much lower valuation. Even in the case where there is revenue from previous attempts, new VCs may suggest that that revenue cease because its defocusing energy from the new “killer app.”

Companies that bootstrap often fall into this trap where they have revenue from several sources making enough to cashflow almost at breakeven, by serving several verticals. VCs tend to see this as scattergun approach, and worry about the team’s ability to focus.

So I really liked this femto deal, the team, even the history because it gave them a unique element of the femto unit, and I could see an ability to build it with some other key elements into not just a femto play but an infrastructure play as well. Unfortunately, I doubt we or any early stage VC will be able to invest in this deal because it can continue based on revenue from the legacy markets with only a little additional funding. The current team is faced with taking a dilutive round to bring in growth capital, or growing organically without dilution. If they land a really big order, they may be able to finance another way.

I don’t know who is right or wrong in this case (history will tell), but from a venture perspective, money is time, and experienced hands to help guide the team and de-risk the business. Looking at a deal when the VC has deep background in the market vertical, and can see a broader, larger opportunity perhaps through M&A, then he expects to get some value attributed to that contribution.

If the company is lucky enough to enter the tornado, a lot more capital will be required and the VCs, new and old, should be happy to dilute in order to bring in more capital to feed growth while the opportunity exists. There is no point for VCs to invest in organic growth and avoid dilution, it's reverse thinking. A strategic M&A can put together the two halves of the killer app (c.f. Light Solutions, my worst and best company … later) to build an opportunity that is perhaps ten times larger, or more critically to create a product that leapfrogs all competitors and secures leadership of a rapidly growing space. How much dilution is that worth?

Unfortunately many companies opt for less dilution and organic growth, but you can’t save yourself to success, you have to spend--so many, many companies find themselves in this limbo where their valuation has outstripped the VC’s ability to invest despite revenue, despite undisputed value--they are in the wrong markets or too diverse, or too much history. Many companies end up in purgatory with enough revenue to survive but not enough to grow and seize the opportunity when it finally presents itself.

I think femto will be a real and exciting market, but I suspect most of it will end up on a chip and whomever makes the capital investment necessary to do that will be the “Intel,” and there probably wont be enough market left for an AMD.

Larry, I saw your ANZA presentation last week in Brisbane... thank you you had some great comments. Having just come back from a scoping trip to the US and UK where we met VC's from Silicon Valley as well as a few clients... our international expansion plans look very positive indeed. One question though... given the exchange rates specifically pound to the dollar...given that the VC we are interested in has offices in London and the valley, what would be your thoughts around the best way to raise the funds? From the UK or Valley office... or how do you think the VC's would view it. I guess my logic is this.... raising $5mill from the valley office means that in the UK that's just been halved, however raising 5 million pound from the UK office is just that to them but its suddenly $10m in the US. I appreciate any comments.
Posted by Anonymous to Larry's VC View at March 19, 2008 6:49 PM

Mate, this is the wrong question, you need to be focusing on which partner in which fund can add the most value to your business – ideally, someone who has built a company like yours themselves, or at least invested in a bunch of them, who can realy help you avoid the pitfalls of others. There is little to your arbitrage concern, since its where you will build your business that will determine $ leverage, and at best it’s a 2nd, possibly 3rd order effect anyway. Don’t get wrapped around the axle on these things, focus on value not valuation; getting the deal done, not negotiation; and good luck with your deal.

Monday, April 7, 2008

The deal that died

So the deal was looking good, term sheet issued, and in negotiation, and deep diligence happening. Then there was a long discussion between Chairman and VC and the deal fell apart.

I got a call from one of the entrepreneurs and was suddenly in the middle of a “he-said-she-said” scenario. Anyway, a group of us got together and tried to piece together what went wrong and whether or not it was fixable. And here’s the rub--VCs really want to invest their dollars (actually it's not even their dollars ... another topic). Their business is to help you build success, so when a deal blows up it means everyone is hurting because they invested a huge amount of time and emotion falling in love, and now both parties have been jilted at the altar.

There are a bunch of probable causes for this--another lover has come on the scene and stolen their hearts--either another VC has offered better terms, or the VCs have seen something scary in the potential partner and got cold feet. Enter the counselor. What killed the deal I am referring to was a syndrome that is very common in non-US startups, and to an extent in non-Silicon Valley startups.

What happened was that there was a CEO and a Chairman and it wasn’t clear who was really the CEO, because in non-US companies, the Chairman has far more control than he does in a US corporation where all he can do is call the board meeting to order--other than that he’s just another director. In non-US companies, he gets to use the Chairman’s lounge at the airport, and that’s not something that he’ll give up lightly, neither the control of the company. Often he became Chairman because he was the original investor, possibly even a founder. Sometimes he is a value-added Chairman, but usually he’s an experienced business guy but not experienced in the market that the company is targeting.

Now he will often bring in an advisor, read i-bank, who will really mess things up; these companies don’t often get through the door in Valley VC firms but are remarkably common outside the Valley and the US in general--this is a really bad combination because the banker is focused on a single transaction, while the VC is focused on building value from three or so rounds of investment and wants to reward only those people who will contribute to the business going forward. The banker is gone after this first transaction, the chairman will no longer have the power or prestige he has today, and so they are both at odds with the VCs.

VCs fall in love with the founders and their idea--young, driven entrepreneurs, particularly engineers, are the life blood of VCs. These young entrepreneurs often look for some grey hair to advise them, and this is a good thing, but the wrong kind of person in this role can be disastrous. Anyway, in the company in question, all the players were good, solid business people, but several of them wanted to be CEO, and as VCs we had trouble working out who was who. As things turned out, the counselor was able to save the situation, and get the deal back on track. To the company’s credit they listened to the VC's issues, understood them, and modified their approach accordingly. It was a stellar result to bring this deal back from over the precipice.

But it never happened. There is yet another problem that kills deals--time. Entrepreneurs frequently focus the negotiation on valuation, rather than on speed of getting the company funded so they can run with the business before someone else does. The negotiation had dragged on so long that everyone had deal fatigue, and in the end, the VCs looked at the other deals they had in the pipeline, and looked back at the original deal with different eyes. Now, six months later, the original deal was not as beautiful anymore, and they fell out of love as there eyes were drawn to other more alluring deals.

It's happened to me, too, all too frequently (with VCs ... and women). But don’t despair, a good team with a good idea will get funded, just don’t get wrapped around the axle on issues that will drag things out beyond the shelf life of a deal. A good friend who is one of the most successful M&A gurus in the US tells me that time kills all deals. Don’t waste time, get it funded, and run with it, show your VCs you are passionate to go, and they will go with you.

Next time: When to take a smaller piece of a larger pie; Femtocells a new wave?