Mark Suster, a venture capitalist/entrepreneur maintains one of the most popular blogs on VC investing. His most recent post provides an effective strategy for entrepreneurs in developing his/her own fund raising strategy http://www.bothsidesofthetable.com/2012/01/16/how-to-develop-your-fund-raising-strategy/.
In Wisconsin and much of the Midwest, we don't have access to the venture capital that one can find in Boston, the Bay Area, San Diego, and Austin, Texas. However, it's valuable to realize that the investing philosophy of Venture Capitalists doesn't differ from the more traditional investors the we find here in the Midwest - lenders and angel investors. Regardless of the type of investor, they are looking for great opportunities with market potential, solid teams, etc. but only differ based on the degree of the risk and reward.
Critical to entrepreneurs is that they understand the fit of their business to the risk/reward profile of different categories of investors. In general, less than 1% of new ventures ever receive financing from traditional institutional funds like venture capital. There are many reasons for this. A larger venture capital fund typically targets a fund internal rate of return of 25% per year or more for their limited partners. That fund, with a limited life of 10 years or so, will typically invest in ten or more companies. Historically, venture capital funds will see a few great investments that will generate a 5X-10X or higher return on the original investment but also see several investments where they might lose all their money. The remainder will return part or all of their principal without a much incremental profits above the capital investment.
Why is this important to understand? A few reasons. First, most VC firms will have a minimal investment they will make in a new venture. It just isn't worth their time to try to manage a small investment with the limited personnel most of the firms have. Second, and this is related to first point, the firms must make multi-million dollar investments in single firms. If they need an investment that will generate a return of 5X or 10X their invested capital, they need a high potential venture to do this. An example illustrates this.
Assume that XYVC investment firm makes a $5 Million investment in Firm Z. In five years, XYVC will desire a liquidity event that will generate a 10X increase or $50 million value. Assuming that the investment firm doesn't own all or a majority of the firm, Firm Z will have to have some extreme growth potential. If XYVC owns 10% of the firm at exit, the company will have to have an total equity value of $500Million or more. At that equity value, assuming a P/E ratio of 10, the firm will need to be at the $50 million level of net profits in only its fifth year of existence. Not many new ventures can meet these needs.
It's critical for new ventures when raising money to understand the investment criteria used by high risk/high reward investors. Doing so will save them a lot of time and effort.
Tuesday, January 17, 2012
Thursday, January 12, 2012
The Entrepreneurial Plunge? Should you?
The economy is beginning to pick up steam and I'm sensing, based on anecdotal conversations with business people, that many folks are getting the entrepreneurial bug. Either they've been out of work and are tired of the job hunting situation or they've been in the same job too long working long hours without any growth prospects. When discussing the prospects of a new venture, before even getting to the crucial elements such as market opportunity, financing, strategies, etc. I try to ask the prospective entrepreneur several questions about the realities of a startup to make sure they have a clear understanding of what they are undertaking and some critical elements that may assist the chance for success. Here's the list:
1. "Does your idea expand on your current knowledge base, experience, and/or skill set, or, is it totally different from what you've done before?". Before even getting to the feasibility of the idea, lots of descriptive research (e.g, backgrounds of INC Magazine 500 founders) shows a correlation between starting a business that you have experience in and the long-term growth of the firm. This makes sense - if an entrepreneur is starting a venture in an industry that they have experience, they will be well-along the learning curve and understand the nuances that the venture will have (customers, industry characteristics, etc.).
2. "Can you see yourself 'loving' what you do in the new venture?", and "Do you feel passionate about the venture idea?". In #1, you try to look for building on the existing experience base. These questions address how will the entrepreneur deal with the first adversity in that he or she faces as they start the venture? It's always inevitable that adversity will arise - key employees will quit, financing doesn't come through when expected, that customer who was so optimistic cools, etc. When facing major issues will the entrepreneur persevere? Critical to know up front.
3. "What's the absolute worst thing that can happen if you make the leap and start this venture?". Such a question gets the entrepreneur to think about the worst-case and if it occurs, what could be the impact on his/her financial, professional, and personal life? Are they willing to deal with the consequences if it occurs (losing a house, not spending as much time with family and friends)?
4. "Have you evaluated what you're good at?" and "What you are bad at?". Knowing your strengths and weaknesses will be critical to understand how your position and life should evolve over the startup's life. Experience typically shows that if an entrepreneur is self-aware of these characteristics it will guide them to identify when they need help and their long-term position with the firm. Also, we typically are happier when we work on things that we're good at. Sales and marketing people usually despise doing accounting for their business. People with accounting backgrounds usually don't like the marketing aspect.
Note, none of these questions get to the business model, financials or any other critical business elements to the plan. They are simply questions that I've found helpful for entrepreneurs to be aware of before making the plunge. Sometimes, it is best not to quit your day job.
1. "Does your idea expand on your current knowledge base, experience, and/or skill set, or, is it totally different from what you've done before?". Before even getting to the feasibility of the idea, lots of descriptive research (e.g, backgrounds of INC Magazine 500 founders) shows a correlation between starting a business that you have experience in and the long-term growth of the firm. This makes sense - if an entrepreneur is starting a venture in an industry that they have experience, they will be well-along the learning curve and understand the nuances that the venture will have (customers, industry characteristics, etc.).
2. "Can you see yourself 'loving' what you do in the new venture?", and "Do you feel passionate about the venture idea?". In #1, you try to look for building on the existing experience base. These questions address how will the entrepreneur deal with the first adversity in that he or she faces as they start the venture? It's always inevitable that adversity will arise - key employees will quit, financing doesn't come through when expected, that customer who was so optimistic cools, etc. When facing major issues will the entrepreneur persevere? Critical to know up front.
3. "What's the absolute worst thing that can happen if you make the leap and start this venture?". Such a question gets the entrepreneur to think about the worst-case and if it occurs, what could be the impact on his/her financial, professional, and personal life? Are they willing to deal with the consequences if it occurs (losing a house, not spending as much time with family and friends)?
4. "Have you evaluated what you're good at?" and "What you are bad at?". Knowing your strengths and weaknesses will be critical to understand how your position and life should evolve over the startup's life. Experience typically shows that if an entrepreneur is self-aware of these characteristics it will guide them to identify when they need help and their long-term position with the firm. Also, we typically are happier when we work on things that we're good at. Sales and marketing people usually despise doing accounting for their business. People with accounting backgrounds usually don't like the marketing aspect.
Note, none of these questions get to the business model, financials or any other critical business elements to the plan. They are simply questions that I've found helpful for entrepreneurs to be aware of before making the plunge. Sometimes, it is best not to quit your day job.
Thursday, December 15, 2011
Venture Capital for 2012
The Wall Street Journal and National Venture Capital Association conducted the annual survey of Venture Capitalists for 2012. There are some interesting highlights from the survey but one that seems to standout is the continued decline in the number of venture funds and the high risk aversion that limited partners are facing based on the economy and markets.
At the same time as fund availability is declining, we're hearing a lot of news about the new startups in social media and other web-based areas. Typically, this is a tell-tale sign that valuations will be under pressure as the supply of funds will not be there for the greater demand from entrepreneurs. In the past couple of years, angels and angel networks have helped fill that void in the early stage investing game. The big question going forward is will the angels still fill this need or will they, too, begin to pull back from the risky environment and/or not having the dry powder of the past.
At the same time as fund availability is declining, we're hearing a lot of news about the new startups in social media and other web-based areas. Typically, this is a tell-tale sign that valuations will be under pressure as the supply of funds will not be there for the greater demand from entrepreneurs. In the past couple of years, angels and angel networks have helped fill that void in the early stage investing game. The big question going forward is will the angels still fill this need or will they, too, begin to pull back from the risky environment and/or not having the dry powder of the past.
Monday, July 18, 2011
The Debt Crisis and Ceiling
The actual raising of the debt ceiling is not so important but the inability of our federal government to address the issues is beginning to spook the markets. If S&P or Moody's were to lower the USA debt rating to AA instead of AAA, the congressional folks don't seem to understand the implications.
1. Many country sovereign funds have a mandate to invest in risk-free assets, AAA bonds. If we lose that rating they will have to shift investments to other countries or markets.
2. Many pension funds, insurance companies and mutual funds allocate a percentage of their investments to AAA rated stuff. This is part of their charter - they must put X% of their overall investment portfolio in safe investments. If downgraded, they would have to re-invest elsewhere.
3. Money market funds (low risk, short-term) put billions into short-term US Treasuries, they would have to re-evaluate.
4. In order to attract investors in US treasuries, the Treasury department will be forced to increase rates on bonds and notes. The interest costs to government will affect the deficit.
5. Mortgage rates are set based on what the US T-Bond rates are. If T-bond rates, this will increase mortgage rates, loan rates to companies, etc. A ripple effect that will be felt throughout the US economy as it continues to struggle to recover.
6. Finally, the US dollar will weaken even more. The US Government will probably print more dollars to 'monetize' the new debt that costs more thus creating a weak dollar for the world. This increases import prices (oil, etc.) and pushes the dollar away from being 'the reserve currency'. WE don't want this.
Talk me off the ledge, please. But not settling this debt crisis in a timely fashion without some long-term plan will potentially have terrible effects over the next years and decades. More important, it's a sign that our leadership in Washington can't lead, even in times near crisis. This is for all our leadership - regardless of party affiliation. Very sad for this country.
1. Many country sovereign funds have a mandate to invest in risk-free assets, AAA bonds. If we lose that rating they will have to shift investments to other countries or markets.
2. Many pension funds, insurance companies and mutual funds allocate a percentage of their investments to AAA rated stuff. This is part of their charter - they must put X% of their overall investment portfolio in safe investments. If downgraded, they would have to re-invest elsewhere.
3. Money market funds (low risk, short-term) put billions into short-term US Treasuries, they would have to re-evaluate.
4. In order to attract investors in US treasuries, the Treasury department will be forced to increase rates on bonds and notes. The interest costs to government will affect the deficit.
5. Mortgage rates are set based on what the US T-Bond rates are. If T-bond rates, this will increase mortgage rates, loan rates to companies, etc. A ripple effect that will be felt throughout the US economy as it continues to struggle to recover.
6. Finally, the US dollar will weaken even more. The US Government will probably print more dollars to 'monetize' the new debt that costs more thus creating a weak dollar for the world. This increases import prices (oil, etc.) and pushes the dollar away from being 'the reserve currency'. WE don't want this.
Talk me off the ledge, please. But not settling this debt crisis in a timely fashion without some long-term plan will potentially have terrible effects over the next years and decades. More important, it's a sign that our leadership in Washington can't lead, even in times near crisis. This is for all our leadership - regardless of party affiliation. Very sad for this country.
Sunday, June 26, 2011
Skype and Stock Options
Techcrunch and other news sources (link) are reporting about how Skype has cut short the stock options of some of its employees prior to the Microsoft acquisition.
A key point with any stock option for employees - read the fine print of the option plan. Look for these things:
1. What happens in event of change of control?
2. What defines change of control?
3. Vesting - does it accelerate or not?
4. What defines 'termination without cause'?
While how Skype is treating the employees by not letting them have all their options or buying them back at what ever the exercise price is, this is their right under the contract signed. Always, always read the option agreement and get good legal advice as to what happens under certain conditions.
A key point with any stock option for employees - read the fine print of the option plan. Look for these things:
1. What happens in event of change of control?
2. What defines change of control?
3. Vesting - does it accelerate or not?
4. What defines 'termination without cause'?
While how Skype is treating the employees by not letting them have all their options or buying them back at what ever the exercise price is, this is their right under the contract signed. Always, always read the option agreement and get good legal advice as to what happens under certain conditions.
Friday, June 3, 2011
Economic Slowdown? Why?
First, I'm a little hesitant to join the 'ledge dwellers' that are announcing that a double dip is coming after hearing all negative economic information this past week and month. The Japan tsunami, floods, higher gas prices and other events have definitely had an impact but we won't know how much until later this year.
More puzzling to me is why the economy hasn't 'taken off' like so many other recoveries especially as related to hiring? Granted there is an enormous amount of debt still possessed by consumers and government but most businesses are having banner years in generating cash flow. Recent anecdotal discussion with a former colleague at an industrial supplier noted that things look strong.
Having been in companies doing long range planning , I have a hunch about the slowness in hiring. Companies are finally digesting the new health care reform and other regulations (e.g., Dodd-Frank) incorporating the costs and benefits into their long-term financial models. Their models may be telling them that labor costs per employee are going to increase dramatically. As a result, they may be holding down their hiring because they see that the incremental cost of bringing on that employee and keeping them will have a negative impact on long-term financial performance.
Companies are funny - they'll look at what the future costs may be and keep the work force levels low having existing workers handle higher demand through overtime instead of hiring new personnel. The companies may be seeing that if they hire new workers, the increased costs for each new worker due to health care is way too high.
More puzzling to me is why the economy hasn't 'taken off' like so many other recoveries especially as related to hiring? Granted there is an enormous amount of debt still possessed by consumers and government but most businesses are having banner years in generating cash flow. Recent anecdotal discussion with a former colleague at an industrial supplier noted that things look strong.
Having been in companies doing long range planning , I have a hunch about the slowness in hiring. Companies are finally digesting the new health care reform and other regulations (e.g., Dodd-Frank) incorporating the costs and benefits into their long-term financial models. Their models may be telling them that labor costs per employee are going to increase dramatically. As a result, they may be holding down their hiring because they see that the incremental cost of bringing on that employee and keeping them will have a negative impact on long-term financial performance.
Companies are funny - they'll look at what the future costs may be and keep the work force levels low having existing workers handle higher demand through overtime instead of hiring new personnel. The companies may be seeing that if they hire new workers, the increased costs for each new worker due to health care is way too high.
Friday, May 20, 2011
LinkedIn IPO - Bubblesville, here we come?
The IPO of LinkedIn brings back many memories for the DotCom bubble of the late 1990s when Internet startups were going public based 'Price times Eyeballs' or 'Price times Clicks' valuation multiples. We all know how that story played out. Should we be worried about the same outcome for LinkedIn? In short, 'no' but a cautionary 'no'.
LinkedIn has a viable business model that has real paying customers that generates a large revenue base and even profits for LinkedIn. This is good. Also, LinkedIn is tied to the corporate customer which is a more reliable long-term payer.
With that said, I get real worried about how contrived this valuation at IPO was done. The company, investors and investment bankers sold a small piece of the company (less than 8% per the Wall Street Journal) to an investor base hungry for new issues. This simply becomes a supply and demand issue - few shares offered to many investors creates an investment frenzy that drives the stock price to abnormal levels. This is great for the holders of existing shares, pre-IPO and great for the company in that it is able to raise an incredible amount of capital. But anybody who bought at the IPO or shortly thereafter will probably see a steep decline in the not too distant future. For investors that bought the stock on the private market like SecondMarket (latest price $35/share there, pre-IPO) may see the shares decline in future rounds.
So, what will probably happen? Pre-IPO shareholders will sell their stock after their lockout period is done (six months or longer). Employees, venture capital groups like Bessemer and Sequoia, etc. will do well. Second, LinkedIn will go on a buying binge of smaller, mobile app startups and other existing companies that will be nice add-ons to the LinkedIn platform using their overinflated stock price to purchase the companies. Finally, we'll now see a frenzy of IPO floats of the other social media companies - Zynga, Groupon, FACEBOOK, and so on. The high valuations for LinkedIn will serve as a justification for high values of these companies and IPO market will sizzle for the next several quarters. The next California Gold Rush will be on. At least these companies have revenues and even some profits.
As an investor who doesn't have access to these companies pre-IPO, hold back and observe. There will be a point in time when the prices of these stocks drop to an affordable level. Assuming the companies can sustain, that will be the buying opportunity.
LinkedIn has a viable business model that has real paying customers that generates a large revenue base and even profits for LinkedIn. This is good. Also, LinkedIn is tied to the corporate customer which is a more reliable long-term payer.
With that said, I get real worried about how contrived this valuation at IPO was done. The company, investors and investment bankers sold a small piece of the company (less than 8% per the Wall Street Journal) to an investor base hungry for new issues. This simply becomes a supply and demand issue - few shares offered to many investors creates an investment frenzy that drives the stock price to abnormal levels. This is great for the holders of existing shares, pre-IPO and great for the company in that it is able to raise an incredible amount of capital. But anybody who bought at the IPO or shortly thereafter will probably see a steep decline in the not too distant future. For investors that bought the stock on the private market like SecondMarket (latest price $35/share there, pre-IPO) may see the shares decline in future rounds.
So, what will probably happen? Pre-IPO shareholders will sell their stock after their lockout period is done (six months or longer). Employees, venture capital groups like Bessemer and Sequoia, etc. will do well. Second, LinkedIn will go on a buying binge of smaller, mobile app startups and other existing companies that will be nice add-ons to the LinkedIn platform using their overinflated stock price to purchase the companies. Finally, we'll now see a frenzy of IPO floats of the other social media companies - Zynga, Groupon, FACEBOOK, and so on. The high valuations for LinkedIn will serve as a justification for high values of these companies and IPO market will sizzle for the next several quarters. The next California Gold Rush will be on. At least these companies have revenues and even some profits.
As an investor who doesn't have access to these companies pre-IPO, hold back and observe. There will be a point in time when the prices of these stocks drop to an affordable level. Assuming the companies can sustain, that will be the buying opportunity.
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