Lowercase Capital

While I am not familiar with their work and investments, I have to say I am impressed by the "Creed" of Lowercase Capital.  They point out several key flaws in the venture capital industry and say they want to find ways to work around them, which is a step in the right direction.  I recommend anyone interested in venture capital take a look:

http://lowercasellc.com/creed/

Understanding Venture Capital

Anyone looking to raise capital needs to understand how their potential investors work.  To borrow a term from project management: you need to understand the stakeholders involved in the venture capital firm as well as how they are affected by investment in your company.  We are going to use a Venture Capital fund in this article, but much of what is discussed is applicable to other forms of private equity investment.

Let’s talk first about structure.  When an entrepreneur looks to raise capital, they usually think of the investor as a venture capital fund, end of story.  Within the abstract idea of “venture capital fund,” however, are generally three distinct entities.  First, is the Fund Manager.  The fund manager is what is typically thought of as the Venture Capital Firm.  Draper Fisher Jurvetson (DFJ), for example, is a fund manager. The fund manager makes the investment decisions and is the group you interact with when you are trying to raise capital. 

The second entity is the fund itself.   When DFJ invests in a company, the fund manager does not us its own capital or own the stock in the company.  The fund managers create separate companies (often limited partnerships) that hold the capital that is invested and any stock in the portfolio companies.  Consider this article that discusses how DFJ earlier this year raised its tenth technology fund.  That means DFJ created a separate company and raised money from investors that this separate entity, called the Fund, holds.  When DFJ finds a company it wants to invest in, it invests the Fund’s money and the Fund in return receives the equity.

The third group is the limited partners.  These are the investors who put money into the Fund.  The fund manager is the general partner of the Fund, and thus the one responsible for running it and liable for any wrongdoing, but these other individuals maintain an ownership interest in the Fund.

As you can see, there are two types of stakeholders in the Fund, the general partner and the limited partners.  Each of these stakeholders benefits from the success of the fund, but how that plays out can be very different for each. 

The next thing you should understand is the Fund lifecycle.  Typically, a venture capital fund exists for only 10 years (with the possibility of an extension of one or two years to allow for liquidating the portfolio company stock).  At the beginning of the Fund’s life, the fund manager identifies the Limited Partners and receives their investments into the newly created fund.  These Limited Partners will not be able to control their invested capital, or realize a return on their investment, until the 10 year lifetime is over.  At the end of 10 years, the Fund is dissolved and the capital it holds is distributed out to the partners.  That means that any stock purchased by the fund (the investments it makes) must be sold prior to the Fund’s dissolution.  Since a typical investment in a startup venture can be expected to last 3-5 years, you can see that there is a limited window of time in which the fund manager can choose to invest the Fund’s capital.  This situation, combined with the weak economy, has led to some serious problems for the Venture Capital Industry, as discussed in this Wall Street Journal article. 

Finally, it is important to understand how the stakeholders actually make money from the Fund’s investments.  The Limited Partners are easily understood, at the end of the Fund’s life, the Fund is liquidated and they receive a distribution from that amount.  The fund manager, however, is compensated somewhat differently.  Fund managers are compensated in a manner similar to hedge funds, an arrangement called “2 and 20.”  While the exact numbers vary slightly (sometimes it may be 1 and 20 or 3 and 20), the concept works as follows.  Each year, the fund manager receives compensation in the form of 2% of the net asset value of the Fund.  Thus, if the Fund’s net asset value is $100m, the fund manager receives $2m that year, regardless of how well or poorly the Fund’s investments are doing.  In addition, the fund manager receives a performance fee of 20% of the return.  For example, if the Fund starts out at a value of $100m when it is created and 10 years later has a value of $600m, the return would be $500m and the fund manager would make 20% of that ($100m).  The remainder, ($400m plus the original $100m) would then be the amount distributed out to the Limited Partners.

Understanding this is important for several reasons.  First, knowing how far into the life cycle of the Fund you are will give you an idea of how soon the investor expects you to have an exit.  Second, when you are trying to determine if you can generate a substantial enough return on investment for a venture capital fund, remember to take into account not only that many of the other portfolio companies will fail (and if you are the one-in-ten big success you will have to make up for their failures), but also deduct the fund manager’s fees from the amount that will actual be returned to investors.

Understanding Equity Investors

I was speaking with a client last week and it occurred to me that most entrepreneurs do not have a solid understanding of how their equity investors intend to profit off their investment.  The investment process is a sales process and, as with any type of sales, the better you understand your customer the easier it is to make a sale.  For simplification purposes, I am going to put the methods for profiting into four main categories.  Bear in mind, there are other ways to profit off investments, but these are four of the most common methods used when considering private companies. 

The first method for profiting is an investment whose goal is to receive distributions over an extended period of time.  The majority of investments that are done in anticipation of the company paying out dividends are friends and family investments. Rarely do funds or companies invest in a business in hopes that it will steadily distribute portions of its profits to the company.

The second method for profiting is through a “strategic investment.” Strategic investors are usually large established companies who see a way to improve the performance of their existing business by owning a part or all of your company.  This could mean that the investor sees synergies between their existing businesses and yours or this could mean that they want to enter your industry or geographic market and believe that acquiring or investing in your company will enable them to do so.  Strategic investors usually are looking to take a controlling stake in the company (if not purchase the company outright) because they need control over your company in order to ensure those strategic benefits.  A major advantage to a strategic investor/acquirer is that they usually will pay substantially more for your business than a purely financial investor would.  Another key advantage is that strategic advisors tend to bring more resources to the table that your business can use in the future, though some funds attempt to provide similar assistance through portfolio companies.

The third method is to bet on a company’s rapid growth.  Venture capital firms are famous for using this method of returning a profit.  Because the stock of privately held companies cannot be readily traded (though some secondary markets do exist for it) it can be difficult for investors in your company to sell their stock.  This has the added effect of increasing the risk of an investment since owning 50% of something that people claim is worth a billion dollars isn’t particularly valuable if nobody can buy it.  Most funds, therefore, rely on the idea of an exit strategy – a plan the company has in place that will enable investors to sell their investment in the future.  Typical exit strategies include acquisition by a large company or initial public offering.  These investors expect to see large sales growth over a short period of time since they usually only have 10 years in which to generate a substantial return for their investors. 

The fourth method is to use leverage to improve your financial return.  This is a widely used method of private equity funds that do not specifically target young, entrepreneurial ventures.  The easiest way to explain how this works is with a simple example.  A private equity fund buys 100% of the stock in a company at a value of $10 million.  The fund uses only $2m of its funds, borrowing $8m to cover the difference from a bank.  It uses the assets of the company it is investing in as collateral for the loan, so if the loan cannot be repaid, the bank goes after the company’s assets first.  The fund holds the company for several years, during which time the value of the company has grown to $12m and $4m of the loan principle has been repaid using cash flows generated by the company.  The fund then sells the company, receiving $12m in cash.  It uses $4m to pay off the remainder of the loan, netting the fund $8m in cash.  The company has realized a 4x return on its investment over a short period of time.

Understanding how potential investors intend to see a return on their investment can be a great advantage in investment negotiations.  If you know your investor is looking to use leverage to improve their return, positioning your company as having steady, reliable cash flows that could be used to pay off debt may make sense.  By comparison, if you are talking with a strategic investor, the consistency of the cash flows may be less important than being able to show how your company will be able to grow quickly or reduce costs through synergies with their existing businesses.  In short, the better you can understand an investor or acquirers motivations, the better you can sell them on your company being a good investment.



Internet Week - Venture Capital & Angel Bootcamp

Last night, David Rose from the New York Angels and Adam Dinow from Wilson Sonsini Goodrich & Rosati co-hosted a great presentation about funding.  The event was simultaneously streamed on live stream and can be found at: http://www.livestream.com/vcbootcamp.  I highly recommend anyone looking to raise capital or building a business that they expect will need outside capital at some point watch it.  David does a particularly good job of dicussing how to put together your presentation for investors and of conveying what the qualities he is looking for are.  Not surprisingly, most of the qualities he points to are ones that reflect the quality and integrity of the team - harkening back to the venture capital mantra of investing in people rather than ideas. 

The video, unfortunately, does not have the ability to skip to the end, so I cannot tell if the Q&A session at the end is included.  I want to mention three quotes from David that came out in the questions which I believe to be particularly important for entrepreneur's to understand.

1) In discussing the usefulness of an advisory board - "Are they contributing?  Names on letterhead don't help."  All too often I see figurehead advisory boards put together by clients.  They assemble a list of names that look great, but none of those advisors make any introductions or provide any advice.  The entreprenuers justify this with claims of the board being "validators" for their business.  If you are going to assemble an advisory board, be certain they will actually advise you.  Investors are aware of the figurehead advisory board problem and will be able to tell the difference between a board that is contributing and one that is not (often because the contributing board will have made introductions to investors or be in contact with them via email to promote the business).

2) "Most investors invest for an exit, not an ongoing revenue stream."  I have seen many entrepreneurs with plans to build good businesses that generate steady amounts of cash that they intend to distribute to shareholders, and who get frustrated when angels and venture capital firms say no to their business.  These types of investors are looking for a big exit (IPO, sale of the company, buyback, etc.) at a single point in time several years out.  They are not looking to make money every year off the company so long as the company remains in business.  At some point, I plan to write a larger post about how funds and individual investors plan to see a return on their investment as I think that will help entrepreneurs better understand why this is.

3) "Ideas are not it, it's execution."  Barriers to entry in many industries have become so low (e.g. internet companies) that presenting an "idea" or a business plan without any sort of prototype is a recipe for disaster.  Entrepreneurs need to understand that the expectation is on having some development done before you raise capital.  Furthermore, this relates back to what David talks about in his main presentation: that investors are focused on the entrepreneur more than the idea.

On another note, Fred Wilson, has a great post today on the Panel Pile Up.  His suggestion to anyone approaching him after a panel or other discussion at which he lectures:  Keep it short.  In his words: "Limit your pitch in this situation to sixty seconds. Communicate three things and ask for one more. The three things are your name and your company, what you are working on, and why you want to meet with me (money, advice, whatever) and then ask if I would do that."  Having been both the panelist getting approached by a dozen people and the preson approaching a panelist, I think this is great advice and will improve the experience for everyone.

Venture Capital - A Success Story

Yesterday, Keith Smith of Big Door Media posted a great blog entry about their experience with Brad Feld of the Foundry Group, a Colorado-based venture capital firm.  The investment process went very well for them, and I wish I could say I have seen more deals go that smoothly.  While the internet is full of stories about people successfully raising VC money, all too often those stories are more about cheerleading than telling a helpful story about how the process went. 

Of course the cynic in me wants to warn people against thinking this is how their investment process will go.  Raising capital is difficult and there are many different personalities in the venture capital community - many of which will not mesh as well with your businesses culture as Foundry and Big Door did. 

There are two key things I think this story highlights for entrepreneurs.  First, the importance of how an investor will get along with you.  Too often, entrepreneurs ignore the personality of the investor because they are so focused on raising capital.  Your investors are an integral part of your company, especially when you are a small firm and they, likely, own a substantial portion of your equity.  If your goals and theirs are not aligned, or if your culture and theirs do not mix well, you can easily wind up at loggerheads with them - a situation that usually ends badly for both of you.

Second, Big Door substantially changed direction during their development process.  "We quickly concluded that we needed to kill everything we had just spent six months building and go back to the drawing board."  Change is a critical idea to building a successful venture.  Very rarely is the business plan you start with the one that you end up being successful with.  Too often entrepreneurs are afraid of change - sticking to their initial idea until that idea has dragged the business down.  The concept is an old one that was well articulated by famed venture capitalist Arthur Rock when he said, “I invest in people, not ideas.  If you can find good people, if they’re wrong about the product, they’ll make a switch...."  More recently, Steve Blank has coined the term "pivoting" to describe this process.  While I find myself incapable of using the cute terminology he does, the idea is sound and Steve's articles on the matter worth reading.

You can read the full blog entry from big door here:

http://www.bigdoor.com/blog/venture-capital-a-love-story/