Saturday, May 17, 2008

Typical Deals – is there such a thing?

Many entrepreneurs go into VC discussions with an adversarial mindset--i.e., it’s a negotiation primarily about price. I am absolutely convinced that this is wrong--you will be at odds with yourself as much as with them--you are trying to sell them on the excitement of your opportunity with a goal of getting them to invest--that’s the prime objective. And frankly price is kind of a second or even third order issue. Founders are also worried about dilution, and so a quick fix to the valuation problem is just to take less dollars, or to chisel down the ESOP. VCs throw up all over this approach because it puts more risk on the company--the team must be firm in the socket, the company must have sufficient capital to reach the next value inflection for the next capital raising.

A typical A-deal (where there may be an idea of a product, little or no revenue, but some clear customer engagement and buy-in, and the elements of a team, or at least a strong technical founder and/or a domain business expert) has a pre-money close to the raise, and a pretty common structure is five on five, so $10M post and the VCs would own 50% of the company. Now “typically” their target ownership is 20%, so you might have a little back and forth and settle on VCs 40% (if you have two, and you should because that means more expertise, balance on the BoD, and around $20M in total reserve for your company--early stage VCs typically reserve $10-12M per deal over say three rounds of funding).

The variance around these numbers will be simply based on the detail, revenue or none, team, etc ... Your target post A-round will be to build out your team, launch the product, and validate the revenue/business model as quickly as possible. VCs are much more comfortable paying salaries out of revenue, and funding high risk new product growth out of investors’ money. To build sufficient value to secure B-round financing, you will want say $5M in revenue, a number of tier-1 customers who are evangelists of your product and team, and you will want a new VC who is willing to pay the higher price of B, this will be a later stage VC who is less comfortable with risk, and therefore happy to pay a higher price for lower risk.

In any investment, it’s critical for all parties to be aligned and share a common goal--your VCs want you to succeed, once they invest they are in the boat with you. Whatever they do, it will generally be to make the company as successful as possible. As a founder or BoD member, that’s your goal as well--and we all sometimes let our personal desires cloud that judgment. What the VCs will worry about on valuation is the post funds: i.e., they will want to ensure that the post doesn’t get too high for the planned performance of the company on this round of funding. Can the company realistically build revenue to a level that will justify a good multiple on that post-funding? If the market is uncertain or slow (like now), they will want to keep the post lower, to ensure that the company can perform and will be able to attract another good co-investor for the next round. In the end, the VCs are not buying a car here, they are trying to build a relationship and help build a company. If the relationship is good, and trusted, risk is decreased and everybody wins.

When you raise B, your A-round VCs will invest more money alongside the new VC, at least their pro-rata (i.e., sufficient to maintain their 20% target ownership). If the company does outstandingly well, your existing VCs will not be able to throw enough cash at the B deal to maintain their equity--are they upset? Hell no, they are ecstatic, they can now “carry” the company at a much higher valuation on their books and their limited partners like that a whole lot better than a down round. You are 110% aligned with your series A investors--the only place where there might be friction is if you have an offer to buy the company. Listen to your investors here, they have been through a lot of these offers, and series A is too early to sell most companies. You will usually do much better by building more value (unless its 2000, and you have a $100M offer and they want you to hold out for $1B … long story).

A “typical B might be $7-10M raise on $20-25M pre--the company needs to be on track to be cashflow positive, and either in the groove for an IPO by the end of B, or positioned to be sold for $300-400M. Either way, you will still take on a C-round, either as mez financing pre-IPO, or to seriously ramp revenue and infrastructure.

Finally, given the metrics of VCs funds, all valuations should be about the same--sure, you can get a mining millionaire to invest a million dollars in your medical device company at a great valuation (but what happens when you need $10-20M and larger economic concerns arise). As an entrepreneur, your deal decision should not be driven by valuation; it should be driven by value.

Tuesday, May 6, 2008

Valuation, Valuation, it’s a rage across the Nation…..

So I just finished a tour of another country, meeting about 700 entrepreneurs from medical devices to enterprise software, with a couple of chip companies thrown in for balance. During the Q&A session there was a lot of discussion around benchmarking deals there to Silicon Valley deals, and can a better valuation be won here? So at the risk of getting it wrong, let me make a stab at that--I think fund economics work in a way that requires an A-round investor to buy about 20% of your company--generally they will want another such investor in the deal, so expect to sell 40%. It doesn’t really matter how much either side negotiates around the deal, at the end of the day they all end up looking something like this magical 20% rule because that’s the only way that the economics of the venture fund will make sense.

Now outside the valley a lot of people think about VC more like the stock market--so the feeling is that once a VC invests, they disappear to go find other deals, and their equity is locked in, plus they get paid dividends over time. In reality what happens, is a B-round comes, and the A round VCs invest again to minimize their dilution. The lead B investor will likely insist that the ESOP is re-upped back to 20%, and that will come out of the A-round VCs.

I need to explain this much better in another posting because it’s the source of enormous confusion, especially in other countries, and I think is at the crux of the adversarial approach to Valuation discussions. The point of this posting is to share an epiphany I had when taking a deal to the partners for approval to go to term sheet.

So what happens in these meetings? Generally there is a formal voting system that requires each partner to either love or hate the deal (on a 1-5 scale, there can be no 3s); but before that all the partners look for a fatal flaw in the company, i.e. something that would kill it in the market and make it too risky an investment [more on that later].

The prime topic of discussion is not valuation--actually its ESOP--if it’s big enough, who else needs to be on this bus and how big a stock budget will we need to attract them. This has all been thrashed out already between the CEO and the partner leading the deal, but its important to second guess based on experience of the other partners with other companies in that space.

Another topic is, can we really add value to this deal--again, its been thrashed out a month or more before when the deal first came to the partnership, but it’s good to review one last time. Do we really understand this space, can we add to the success of this deal?

A number of other issues come up, and then it’s deal structure. How risky is the market looking forward--under the current economic uncertainty a number of areas could be tough. IT spending will decrease and it will get harder to build startup revenue, so a B-round deal will likely suffer in valuation because the investors know they need to carry the company longer to get through the coming rough patch.

If there was a previous round, it’s likely that that VC isn’t terribly affected by valuation of this one, provided he is investing pro-rata, because the new money dilutes the old. If valuation goes down, his pro-rata gets a greater percentage to compensate; if it goes up, the original investment is worth more to compensate. What he does care about is the dilution due to ESOP increase because that comes mostly out of him, but at the same time he knows the company needs to attract more talent.

So here’s the rub, if the ESOP keeps getting topped up with each round, then the Team who build the company gets minimal dilution (or the company grows rapidly and the shares owned by each member become much more valuable) – so ironically, the VCs dilute themselves. Does this worry them? Of course not, because the pie is getting bigger. I am convinced that this is the only way to look at valuation, from either side. If we are obsessed with the percentage we end up owning a lot of nothing. If the company is really successful whether you own 20% or 30% you still make money and the fund succeeds, if it fails, owning 90% isn’t going to help much.

My epiphany came when my partners voted the valuation up, and nuked the milestone tranching the deal – this was a deal with some history and potential performance issues. When VCs tranche a deal, i.e. fund part now and part later after the company hits a pre-determined millstone, it’s highly unlikely they will ever use the milestone or withhold the second tranche--they are just trying to ensure the team is really 110% focused on the issue that defined the milestone.

The fact is that markets change and the team is the only element that can respond, so a milestone drafted today is probably meaningless in 18 months. So why have the milestone if it isn’t really going to help, and is more likely to put investors at odds with the team? The VCs voted in favor of removing it because they wanted to align themselves with the Team--this alignment is critical for a successful partnership going forward to build the company together. Likewise, making the valuation a little higher can remove weeks of wasted time negotiating, and turn what would have been hard feelings from the Team, into feelings of support and aligned interests--what is that worth?

I’ve been through a really bad turnaround where I was brought in by Intel to triage one of its companies. The problem in that deal was misalignment between investors, and between investors and Team. It nearly killed the company. In contrast, when I ran Lightbit, we navigated through tech nuclear winter, and the VCs (Mayfield & Accel) with whom we had been brutally honest and built a strong trust helped us carry the company (of course, many of us stopped taking salary for a year as well ;-) ).

Next Time – Typical deals (or the second part of valuation)