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.

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)

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 http://en.wikipedia.org/wiki/Femtocell)--for 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.

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?

Larry responds ...

I wanted to respond to some of the posts and questions, so I will do that in this BLOG and post “The deal that died” next time. Please keep the questions coming, or propose new BLOG topics, it really helps me focus on what’s important to you.

Joyce said … Hey Larry - what are your top tips for crossing the chasm? Also, how can I persuade engineers that one or two Evangelist Clients does not guarantee commercial success (without demotivating them)?

I always liked Geoffrey Moore’s chasm talk – he’s the only guy I know who can whip through 75 slides in 20 minutes ;-) we had a great breakfast a few years back (at Il Formation) … this is what I learned:

The early adopter is the heart and soul of your initial marketing process – without them there is likely no real business. They have to value your technology (unlikely you have a real product at this stage) way beyond the money. They need to see clearly the unfair advantage that they can gain with you and be willing to put up cash to validate it. Often they will pay NRE to craft the technology into the product that they critically require – particularly in hardware companies. They will pay a premium to get the unfair advantage to grow their market. They will tolerate all types of problems, provided you properly set their expectations because they share your vision of what could be. Beware the tire kickers who are price sensitive and skeptical who can trash your “product” and stifle your growth – pay them no mind at this phase because you are simply not ready for prime time yet. Now, Joyce is right, you will start to kid yourself that you have made it because these evangelists love your technology and you are making “sales” – but the fact is, what you are really doing is developing your product and crafting your marketing, and sales processes – these are just as critical (and just as much processes) as product development. It gets very scary when you run out of early adopters because suddenly sales evaporate, and you don’t know where to go next except down into Moore’s Chasm.

If the early adopters are properly mined, then you have the beginnings of marketing – these early customers can become evangelists who will be your best initial sales force – if you have chosen correctly these people will be respected and followed by the mass market and even the skeptical customers will start to pay attention to you. Beware, you don’t get second chances with the skeptics – so make sure your product is solid, and you understand the sales process. Your early adopter who should have helped you navigate thru the internal process of their company so you have the beginnings of a sales process, the touch points, the decision makers – can you close a skeptic? Your sales process will need to morph as you learn and you will iterate many, many times, but you will develop the process and ultimately use it to win more and more customers.

I want to use Adrian, as an example here – he sells chip level software (more like hardware to me). Now Adrian tried shooting elephants, but they are hard to down, so after a while he learned that shooting squirrels is much easier and after a while he secured about 80 such customers, albeit smaller order sizes. Seeing this proliferation, his early adopter customers got even more excited and took him to their internal skeptics in other operating divisions who ended up signing near-exclusive agreements to use only his product across all their product lines. He broke from small volume early adopters, to mainstream mass market in about two years. Don’t be discouraged – it takes a lot of squirrels before you are ready to bag an elephant. I’ll write a BLOG on this soon.

Anonymous said … Can you write your next blog about great entrepreneurs going to the dark side?

So meet my buddy F who was a great product manager in telecom – he rolled out some of the most successful products in the early days (pre-bubble) of optical networking. A couple of years prior to the Internet and subsequent telecom boom, F saw what was coming and raised $45M to fund a revolutionary kind of optical transport company. Actually, initially he went to senior management and tried to convince them that this product would dramatically grow their business, but they were unable to see his vision. So F founded his first startup. He was funded by a dear friend of ours, who, during the telcom boom, was the most successful general partner at one the top three Sand Hill Rd venture firms.

In two years, his company had built a revolutionary new type of optical transport system and it was with great pride that he walked into his board meeting in early 2000 with an offer to acquire the company……for $1B…..!?! Now I still remember clearly his excitement at the offer, followed by astonishment at his board’s rejection of it – imagine $45M invested, $1B exit in just two years – it was unprecedented. What on earth was his board thinking? To quote one of the leading VCs at the time, “it’s not enough.”

Now many of us have been through this experience, very few at this price level, but many at far lower prices – and the shock of rejecting a perfectly good offer generally compounded into deep regret because the later offers (especially in 2001 and 2002) were far, far lower, or non-existent.

So F went back out into the market, continued to build his business, and later that year sold it … for over $3B!!! I guess this time, it was enough. With such a stellar return he was invited to become a partner at one of the leading firms, but decided, in a very entrepreneurial way, to control his own destiny, do his own investments and be a part time venture partner there. After a while, he took over a venture fund for a large corporation, and after making that fund good returns, he joined one of the rising stars in venture firms and continues to make great investments.

So what does F say about his journey? The hardest thing was realizing that he wasn’t an entrepreneur any more, i.e., he couldn’t do it all himself – he had to become a coach not a player, he had to learn to let the entrepreneurs do it themselves without jumping into every sales situation and deal and taking control. One of the characteristics I always notice when he hears a pitch, is that he stops the entrepreneur from diving into the story, and makes them talk about themselves – he has that uncanny entrepreneur’s instinct of judging character and will often get to know the entrepreneur for half of the initial meeting. It puts many entrepreneurs off (especially those who get embarrassed talking about themselves, i.e., mostly Aussies ;-)), because they want to talk about their products and companies.

F tells me he can make the general decision to invest simply from that first half-hour of getting a feel for the character and historical experience of the entrepreneur. He also is a great believer in first-time CEOs, not just because he was one, but because of their unique characteristics (discussed in an earlier BLOG). The other great characteristic that F has, is the ability to help the entrepreneur, in most cases strengthening their plan by seeing flaws in it that he himself has experienced. In a later Blog, I’ll try to get permission to tell Milton’s story, who is the most successful entrepreneur turned VC I know, but he’s pretty humble and won’t like publicizing himself. The other one is Kevin Kalkhoven, who took JDSU from a small OEM laser supplier to the largest optical component supplier in the world, then rolled over his gains to set up KPL ventures.

Mudmaps said … So Larry - tell us why you want to be a VC now? And why VCs want entrepreneurs in their ranks?

The other VC I wanted to mention in entrepreneur-to-VC transition was Dado Benato who founded Tallwood after building a very successful semiconductor company, and then doing a stint at Mayfield as a VC. Most VCs in Silicon Valley come from the ranks of entrepreneurs. I know that in other places VCs are often bankers, especially from private equity, but not here. Its scary being on the other side of the table, because I always thought it was hard to raise money from VCs, but never appreciated how positive and optimistic they are compared to limited partners, from whom VCs must raise their money ;-)

I think six startups is enough, and it’s time to help other startups get funded, and be successful. In 2005 I took a group of US VCs down to Australia, when that government was reviewing the venture ecosystem. Often it’s best for governments to get advice from independents who have no local political agenda. I’ve been in the US for 20 years this year, and I was shocked at the changes in my country. I saw a substantial unfulfilled need, and like any entrepreneur, an opportunity to fill it. I like many VCs, I also have had some bad experiences with them – I would like to be a different kind of VC, and I think there is a better chance of succeeding at that being a serial entrepreneur. Now, there’s a lot I don’t know (and I’m discovering more every day!) but VCs are supposed to add more than just money to their investee companies – that’s why they want serial entrepreneurs in their ranks.

Dado spends a day a week companies he is invested in and on the BoD of – his success metrics are exceptional. When asking for advice on how to be a better VC, one answer I got was this – “I don’t think the term VC is a meaningful term – your fund is a startup, like the companies you invest in. Focus on being a good entrepreneur for that startup and you’ll succeed; and if you do ever work out what a VC really is, please let me know” – I think that’s great advice for all of us ;-)

Share market crash: timing is everything!

In the midst of a major bear market, with global economies faltering and a worldwide credit crunch, it’s hard to see the future--I just witnessed a record one-day point drop on Asian markets and saw 12 IPOs cancelled indefinitely.

A couple of years ago I was starting the first day of a roadshow and the front page of the nation’s major financial paper read “Biggest one-day point drop since 911.” When it turns it turns fast. Everyone runs for the exit but there is no sign of an exit. It’s an ill wind that blows no good for someone. Let’s be realistic, some investors made far more on the 2000 market crash than most made on the rise--shorting stocks and the beneficial tax consequences created massive wealth for many--though not me unfortunately ;-).

For entrepreneurs, economic downturns can be good. Obviously if you are in the middle selling or IPO-ing your company, then it’s bad, but if you are fund raising it can be exceptionally good. Of my six startups, all but one was founded in either a recession or significant economic downturn--these are great times to start companies inventing and/or developing products that will come onto the market in a year or two. Established competitors are downsizing and slashing R&D to appease a falling market, while you are investing venture dollars on a far longer timescale than next quarter.

In a recession, everything is cheaper--employees are better and easier to recruit, materials are more available, and suppliers are eager to help you if you have money ... so how do you get money in a recession? It’s clearly not a great time for bootstrapping (unless your friends and family have nerves of steel)—it’s human nature to think the sky is falling once markets slide, and everyone fears for their future. Think back to 1999 and the ease of raising capital; 20 companies were funded in the same space when five years before two would be lucky to launch.

Unfortunately the size of the market didn’t really support 20 startups, and customers used the abundance of competition to drive down prices and force most of those startups out of business. Ironically, when the so called tech wreck hit, funding stopped and many companies hit the wall especially in internet and telecom. However, new areas won big, and many VCs kept investing – cleantech was born, solar cell companies were founded, and social networking found its beginnings.

It’s true that many VCs downsized their funds from $1 B to $0.5 B but they kept investing, this time in a manageable number of deals. Seven years later, VC funding has finally exceeded its 2000 peak--will there be a pullback similar to equity markets and real estate? Sure, but it wont stop, simply the quality of investments and entrepreneurs will get better. If you have a great idea, and a market exists in the two-year time frame, you will get funded, and by the time you come to market today’s bear will be a bull again.

A corollary to this “timing is everything theme,” is, when they pass the hors d’oeuvres, make sure you take two--I have never met the CEO who saved his business by avoiding dilution, but I know a lot who went through bankruptcy proceedings because of failing to raise sufficient capital. If you waste too many cycles on negotiating a term sheet trying to angle a better deal, the market can move past you and you end up with nothing.

VCs can be predatory in bad times, but they also get preyed upon in good times--if you can find an investor who will treat you fairly, and you believe you can build a strong long-term relationship it’s often a good long term decision to give on valuation in favor of the intangibles. You will be together for a long time, and markets will undoubtedly get bad at some point in your relationship--a good foundation and history can often carry you through when others fail … and sure, your VCs can help too ;-)

Next Time – “The deal that died”

Do you want to be rich or king?

This is a tough one--many VCs say that their entrepreneurs get wrapped around the axle on being the CEO (king). An old friend who ran HP labs for 20 years once told me that when people come to the Valley from elsewhere, they focus on three things--title, salary, and equity, and in that order; when in fact they should be in the reverse order with title a very very distant third. At HP the authority of knowledge overrode everything else.

After a few years in the Valley, most engineers recognize the futility of title, the lack of economic benefit in 50% money (i.e., the government takes half what you earn); but many reap the rewards of stock and options that build real wealth over time and attract lovely tax treatment (AMT not withstanding!). Now sure, many others held worthless options, but before the 2000 era, companies that built real value and solid quarter-to-quarter revenue growth went public and made real wealth. Post 2000, Google turned every rental tenant I had in Mountain View into a buyer wanting to do all cash deals (one actually offered Google stock … don’t ask!).

So if you are too focused on being the boss, you are focused on wining the wrong battle--it’s a very rare CEO who can invent, found, run through pre-revenue development, cross the chasm to growth phase, get the company public, and run it as a public entity. Interestingly those rare few who can evolve with the company’s growth usually do a stellar job but it’s a high risk proposition for investors. You must be focused on building value in any way you can--if you can recruit a start CEO who is better than you, then you need to be first in line to bring them on board; don’t wait for your board of directors to tell you.

So what’s my take on this debate? I think startup CEOs and founders should want to change the world (even just a little)--they should not be motivated simply to get rich. Greed alone is never enough to sustain you through the really hard times. The best founders are often people who tried to get their employer to pursue a new strategy or product but could not get buy-in from management; frustrated and wanting to serve more customers better, they leave and do it themselves.

Also, if you just want to be rich, you are temped to sell too early--think about the founder/CEO after first-round financing who might still own 30% of his company--a $30M offer to buy before substantial revenue is a life changing event for the founder vs. the risk of raising a B round to generate real revenue and build sustaining value (this is a real example that is happening as I write). Now the founder I’m talking about is a deeply dedicated entrepreneur driven to change something in the security market that has driven him crazy for years. He has quietly gone around getting design wins and a solid B round will launch him quickly into substantial revenue.

Consider the agonizing decision. $10M in his pocket is enough to change his life (more on this later). It’s not enough to change his employees’ lives, and this is a solid close-knit team that has fought long and hard to build a strong business. The dilemma for this founder is what he would do next. He has no interest in working for a big corporation--he’d probably start another company instead—but doing what? Probably what this firm does.

So after spending a while with the acquirer he turned the acquisition offer into a partnership and stove off a potential competitor (make vs. buy decisions are tricky to manage). He’s in the process of raising a B-round now, which I’m sure will be easy to do, and with that he should be able to build a $300M+ company, of which he’ll probably still own close to 20% and turn the $10M exit now into a $50M+ exit. But … maybe he’s another Phil Merrick and capable of driving this business all the way through an IPO … putting more than $100M in his pocket and making his investors and employees very happy.

I have never sold anything and not regretted selling it in hindsight (especially real estate), including IPOs that were perhaps a little too early. If you love working with customers and creating products that serve their needs better than what’s out there today, then you will change the world (even just a little)--what better driver could you have to be an entrepreneur?

Next Time: Share, market crash, and timing is everything