Rocky Top MBA

CMM December 10th, 2009

Over the past few days, President Obama has turned up the rhetoric on small business growth. He’s held summits (we won’t mention the attendees and who wasn’t invited), he’s included a new laundry list of talking points, and issued a round of encouraging statements. This past Tuesday, December 8, the president even went so far as to suggest “a complete elimination of capital gains taxes on small business investment” for one year.

Unfortunately, members of his own party were not listening.  Or, maybe they were but they chose to disregard the president’s guidance. Yesterday, without a public hearing or committee vote, the Democratic controlled House of Representatives voted to raise the tax rate on carried interest paid to equity fund managers to 35% from 15%. This 133% increase was accomplished by reclassifying carried interest from a capital gain to ordinary income. That’s why today’s headlines should read “House of Representatives Loves High Unemployment, Punishes Job Creators.”

How Does Venture Capital Work?

While this bill applies to many investment groups—including broader private equity, real-estate partnerships, and oil-and-gas partnerships—my perspective is focused on the affect of small business growth resulting from venture capital investment. Venture capital is high risk portfolio style investing that utilizes equity and equity-like investment tools for the purposes of providing development and growth capital for start-up companies. Companies fitting this profile typically have a curve-jumping quality, focus on an underserved and growing market, and have all kinds of risk due to their infancy, sensitivity to the overall economy, and dynamic change factors. As a result, most venture investing is done with a portfolio approach and with a significant return-on-investment expectation.

Investment capital is typically raised from institutional partners such as endowments and pensions, with the occasional inclusion of a high net worth individual. These investment partners compensate a staff, led by fund managers, to manage the investment capital and the portfolio investment. This staff has two methods of compensation, through an annual management fee and with a carried interest bonus upon liquidation of the fund. The management fee goes to pay all expenses, including salaries of the fund, for the life of the fund—typically around 10 years. In my experience, staff members have lower salaries than they could find in other industries, with the majority of their compensation coming in the form of the carried interest bonus. For purposes of this conversation, these salaries are taxed as normal income.

Over ten years, the fund may invest in a handful of companies. Some of those companies may fail, some may break even, and a small number will make a significant return. At the end of the fund, the goal is to return all investment capital to the investment partners, plus the additional money made off the fund. A portion of this additional profit is set-aside as a carried interest bonus to the management team. Traditionally, this bonus has been taxed as a capital gain because of the nature of its source—the money comes from a successful investment and is not a guaranteed return. The money occurs after many years of tedious and patient management of investments.

Changing the tax structure on carried interest changes the economics of incentive for the people that work in venture capital. As financiers, we’re very sensitive to the idea that there is a cost to the capital we deploy. If we fail to meet that hurdle, our investors will look for other investment opportunities. Likewise, there is a cost to the time and resources we commit to managing that capital. If our compensation doesn’t justify the stress and commitment necessary, we’re likely look for alternatives. Ultimately, less potential carried interest return to the management team leads to increasing salary compensation, which results in less capital available for deployment. The other alternative is that we run the risk of venture capitalists seeking careers in other industries. While there are arguably too many funds active today, the mind set and culture of the venture capitalist is a rare animal. Run too many of them off, and you’ll find this to be an endangered species and industry.

Why Should I Care?

To put it bluntly, venture capital provides a unique and critical service to our economy—capital and guidance for start-up companies. According to U.S. Census Bureau data, companies less than 5 years old created nearly two-thirds of net new jobs in 2007. While not all of those companies were candidates for venture capital, a substantial number of them were rapidly growing businesses serving unique market needs. These companies often lack the assets or history to secure debt, making an equity investment like venture capital a lone source of financing. Without access to capital, those companies grow at much slower rates or even close down completely. Our small business economy isn’t a recent phenomenon; it’s been the staple of our economy for the past fifty years. The small business economy and innovation spurred companies like Microsoft, Apple, Oracle, and Amazon to name a few.

Tinkering with the economics of venture capital is playing a dangerous game.  While the short term intent may be to supplement incentives in other areas of the economy, the long-term effects may be regression of small business growth and capital deployment. Why punish a critical piece of the mechanism responsible for two-thirds of business growth?

• Venture Capital
• Comments(3)

CMM August 10th, 2009

I know it’s a little stale (seeing as it’s now August 2009), but here is a little commentary from the folks at Kauffman on the activity of angel groups in 2008. In case you don’t want to read the whole thing (Kauffman folks are typically long-winded, although this is relatively brief) here are some key considerations:

On deals (micro-economic):

• 2008 average investment per deal was $276,918
• Average number of investments was 6.3
• Average number of new investments was 3.7
• The largest identified sweet spot, with over 40% support, was between $250,000 and $500,000

On the investing (macro-economic):

• More than 2/3rds of respondents think current economic conditions will extended until 2010
• Uncertainty of the economy, a desire to preserve capital for follow-on investment, and loss of wealth were identified as the primary reasons for closing less deals
• 2009 will bring more quantity and quality deals for angels
• The current environment is providing more attractive (author’s note: and realistic) valuations
• Nearly 3/5ths of respondents expect the liquidity time line to be greater than five years
• Respondents expect to increase their co-investment with other angel groups, early-stage VCs, and individual angels
• Angels are increasing management activity and follow-on investing

• Angel Investment , Venture Capital
• Comments(0)

CMM July 2nd, 2009

The data for this analysis came from NVCA, who has a relationship with Thomson Reuters. You can find the NVCA press release here.

Basically, Q2 of 2009 showed some signs of life out of the IPO market with five offerings, four from into tech and one from non-high tech. While we’ll celebrate those as the first real high technology IPOs since Q1 2008, we can’t over do it. We’re still a long way from the IPO payday; for example, in 2007 there were 86 IPOs for the year. The IPO market imploded in January of 2008, which in hindsight was probably an early sign of the financial fiasco we’re still struggling with to this day. I still feel like lots of politicians were trying to talk us into a little recessionary dip with pre-election angst and finger pointing, but in retrospect I don’t think I paid enough attention to the stalling IPO market. But I digress…

The venture industry needs liquidity events. Right now, many funds have all capital tied up in portfolio companies that can’t exit even though they’ve reach profitability, or the fund is tied up pumping capital into companies unable to raise additional outside equity. Either way, funds are limited on their ability to engage in real value-add, early stage investing. In addition, some funds are taking huge cram-downs and dilution as portfolio companies go through recapitalization and down equity rounds (i.e. raising money at lower valuations than before). Now, I’m not waving a “poor pitiful VC” flag. I’m just saying we need a healthy, vibrant, and liquid venture industry to keep entrepreneurship going.

The thing about entrepreneurship and early-stage investing is that it’s an expertise lost to the general public and most public officials. Frankly, you don’t really hear major media reporting on innovation, new business creation, IPO registrations, and patent filings. It’s all too complicated for the average Joe or Mary, so real high-growth entrepreneurship seems reserved to those fringe elements of society. Lots of people want to claim some title in this arena (angel invstor, entrepreneur, etc), but few of them really have the somatch and even less ahve the know-how. In addition to the complexity and unknown of this space, the target is always moving as a result of disruption and hyper competition. In my experience, working in this industry requires a high level of commitment to learning and a deep humility/sensitivity to how much you need to learn and relearn each and every day.

In conclusion, we’ve seen some sign of life in the IPO market, but we’ve still got a lot of capital clogged up in venture-backed companies. Exits are approximately 60% of their high over the past five years, with IPOs still anemic.

Here are some graphs showing venture0-backed liquidity events in the US (sorry for the poor pic quality):

• Economy , Entrepreneurship , Venture Capital
• Comments(1)

CMM August 28th, 2008

The world of entrepreneurship is a wilderness. It’s harsh, it requires a survival instinct, and it punishes bad decision-making. Contrary to some expectations, it isn’t a city-park-greenway-with-swings kind of wilderness; we’re talking about deep-jungle-savages-with-spears kind of wilderness. It takes a total commitment to living on the edge, not a commitment to the sexy, TV-friendly version of entrepreneurship. It takes time, careful planning, and proper execution just to survive. But with a little luck, all the hard work pays off with a profitable and rewarding exit.

The journey through that wilderness isn’t without the occasional victory. One of the earliest inflection points of a start-up is securing that first round of outside investment. Right as the entrepreneur has almost topped out their credit cards, exhausted their savings, and been banned from family dinners due to borrowing from relatives… the oasis appears!

In the life of a start-up, there are few events more exciting than raising the initial round of funding. This initial round, often called the seed round or seed capital, is some of the most critical but most difficult to raise. This money goes for flushing out the business model, building the prototype, protecting the intellectual property, getting critical market validation, and beginning to generate early adopter revenue.

In addition, it marks an important point in the entrepreneurs maturity. They’ve probably gone a few months without an income… and outside investors mean an actual paycheck. It feels so good, they won’t even care that the salary is 1/3rd what they could earn in corporate America.

Unfortunately, there is a problem with securing seed money. The risk and lack of revenue associated with a seed investment is a turn off for most institutional investors, and most high net individuals are too busy investing in real estate (or maybe that’s just in East Tennessee?). As a result, many potential entrepreneurs lose hope, run out of savings, and eventually throw in the towel. While this lesson is critical for technology start-ups, it happens across the board, from lifestyle, to serial, to social entrepreneurs. Academics have identified a funding gap between traditional venture funds (which focus on growth and expansion opportunities) and seed investments.

In order to be successful at raising seed capital, and to avoid major complications in later stages of fund raising, entrepreneurs should develop a fund raising strategy. The idea that “all money is good money” is a bad idea that gets good entrepreneurs into horrible, dead-end situations. Remember, there is no such thing as a free lunch… so consider the conditions (both legal and implied) that come with every outside dollar you raise. Make sure every dollar raised creates the kind of value that grows the company beyond seed and into the growth stages.

Some points for consideration are as follows:

Seed Stage Funding Sources:

• FFF– The classic friends, family and fools. Unless an effort is backed by a research institute or corporation, most start-ups rely on founder’s capital and resources to get the concept nailed down, technology flushed out, and business plan pieced together. It can be very beneficial to be an early investor, since this money gets to experience the most value gain over time. Likewise, early investors typically get diluted (or see a decreasing stake in the company) with the entrance of larger institutional players. That’s usually okay, though. Institutional money can make the difference between owning 20% of a hot dog stand of 1% of a MacDonalds. Be careful with FFF and how the deal gets structured. Later in the companies maturing, it will be tricky to raise money if the earlier investors are at odds with potential future investors.
• Grants– Free money! Well, mostly free besides the time spent battling the annoying application process. Common resources for grants are federal grants like the Small business Innovation Research grant. Aside from providing capital, these awards are 3rd party validation for the concept.
• Boot Strapping–Boot strapping is the funding strategy for most non-serial, non-technology entrepreneurs. This is a great way to establish a lifestyle company (one with no desired exit, but with intent of operating under founder’s control to provide income for a certain lifestyle). As revenues grow, the company is able to increase its relationship with the bank, throttle up cash flow, and expand operations.
• Angel Investors–Angel Investors come in many shapes and forms, which makes it difficult to understand what someone means when they claim to be an “angel investor.” Also, there are lots of decoys out there… people claiming to have access to angel money but with no real ability to invest. Depending on what the angel brings to the table, the deal should be assembled accordingly. An angel with industry experience and a willingness to serve as an adviser or board member should have more seniority and stronger investment rights. An angel without the resources or acumen should be treated as a typical FFF investor. Some would even argue that angels without special resources or acumen aren’t really angels… they’re really just part of FFF fund raising.
• Institutional Seed Investors–Before its all said and done, almost every technology start-up needs some kind of institutional investment. Institutional investors are the true commercial venture and private equity funds. Venture and private equity money is supposed to be “smart money.” Be careful… there are many groups passing themselves off as venture funds without the resources (and most importantly capital) to support their claim. A real institutional investor will have provide the start-up with access to their network (both industry specific and fund raising), provide operational value as an adviser or board member, and be able to offer fresh and relative opinions.

Concerns:

I can’t believe I’m making this recommendation, but when it gets time to negotiate the terms of a seed round, I recommend the entrepreneur bring their own lawyer to the table. Certain lawyers specialize in business formation and investing, so they have the acumen necessary for writing the appropriate investment documents.

• Valuation– This needs to be a post all its own. Raising too much money or at the wrong valuation cause cause major problems in the long run. The most frequent mistake of naive and rookie entrepreneurs is trying to raise money at too high a valuation. Typically, $500k seed investment in a company that is pre-revenue, pre-prototype, and pre-IP (patent) is going to purchase 35% to 45% of a start-up. This isn’t written in stone, but its a good starting point for negotiations. The longer the company waits to raise seed money and the more value squeezed from founder’s capital, the better the valuation. For example, a company raising a frist round of seed money that already has a patent filed, a prototype built, and recurring revenue off a small number of beta customers is going to give up much less than a company with only a business plan and pitch.
• Anti-Dilution– Some companies are tempted to include an anti-dilution clause, which is a BAD idea in my opinion. Early ivnestors should have tag-along rights (or the option to invest pari-passau) with future rounds. The harsh reality is that most early investors, won’t have the cash reserves to follow-on with later institutional investments. As the multi-million dollar investments close, ownership percentage becomes diluted for both early investors that don’t participate and founder’s equity. This is natural and to be expected, so entrepreneurs should manage expectations with the FFF. Like I said earlier…. 10% of a hotdog stand or 1% of a MacDonalds.
• Investment Tool– There is much debate around what type of tool to use with seed investors. Typically, investments are made as either common stock, preferred participating convertible stock (yeah… a mouthful!), or as convertible debentures. Personally, I think REALLY early institutional seed money should be raised as convertible debentures, founder’s equity should be treated as common stock, and only after revenue generation and market acceptance should preferred equity tools be used.
• Voting Rights–If you’ve ever heard the old saying that “a donkey was a horse designed by committee,” you understand the danger of having too many people involved in the company’s decision-making process. Giving voting and board seats to early investors can create complications and frustrations long-term, not to mention deter insituional investors. Some seed investors are of great value and should be awarded board seats, but in my opinion these true angels are rare. Giving Uncle Bob and your college roommate preferred voting status and/or board seats in exchange for $20,000 is foolish. Its one thing if they are industry experts… but giving them seniority because of their relationship is naive at best.

Check back soon for future posts on:

• Setting a seed stage valuation
• What happens when entrepreneurs do bad seed deals
• How to be attractive for seed fund raising

• Angel Investment , Entrepreneurship , Venture Capital
• Comments(4)

CMM June 11th, 2008

Pitching is the art/science of presenting your idea (see knifty picture) to interested parties. Since the audience may change with need (customers, validators, investors, employees, etc) and the need may change with maturity (seed, early, expansion, growth, etc), it is only natural that the pitch changes. Regardless of the audience, most good pitches come from a modifiable template that starts with a “hook.” The hook serves the purpose of getting the attention of the audience and should leave them wanting to hear more or ask questions.

Guy Kawasaki has a post about How to Pickup a VC. After going through 10 rather hilarious ways on how not to start a pitch, he gives the one sure fire way to do it… cut the crap and get to the chase. My military buddies call is the KISS principle– Keep It Simple, Stupid. Don’t feel obligated to demonstrate your superior knowledge or the technology’s awesomeness in the pitch. Instead, focus on the problem and your solution. Then, you can demonstrate your knowledge and preparedness  in the follow-up questions (and meetings). Think back to dating. You don’t land a date with “that girl” by using cheap pick-up lines or self-promoting. You landed that date by focusing on her interests. VC’s are the same way. Focus on their interest (see my writings on the investment profile). 

My favorite from Guy’s list… Entrepreneur says: “I’ve always wanted to be an entrepreneur.” Venture Capitalist thinks: “… and I’ve always wanted to be a professional golfer.” In my case, I’ve always wanted to be the lead guitar for a blues/soul/rock band.

• Entrepreneurship , Venture Capital
• Comments(1)