Thursday, July 9, 2009

How to Invest in a VC Fund

So you always wanted to be a partner in a venture capital fund? Well, here's how it works.

The following is Part 3 of my five-part series on how to invest in early stage technology companies as an angel investor or through an investment in a venture capital fund. Privately held companies in emerging technology sectors--such as nanotech, clean tech, biotech, info tech and new media--frequently have exciting upside potential that can only be fully harnessed by investing in them when they're in their infancy.

In Part 1, I gave a general overview of the playing field and in Part 2, I examined the stages of an emerging growth company’s lifecycle and the types of investment that it hopes to obtain at each relevant stage.

Here, I'm going to explain how you can invest as a limited partner in a venture capital fund.

When you invest in a venture capital fund, your role in the early stage company will be completely “hands off.” You're investing in the vision and/or track record of the venture capitalist and will rely on the venture capitalist to make and manage your investment decisions. It's crucial that you match your investment goals with venture capitalists sharing similar goals. For example, an investor that wants to maximize exposure to nanotech and its commercialization would not want to invest with a generalist venture capitalist or a venture capitalist focused on the Web 2.0, SaaS or cloud computing sectors.

Before you invest in a venture capital fund, there are several things to consider which I detail below the fold.

1. An investment in a limited partnership in a venture capital fund is long term and illiquid. Long term in this case typically means it will be 10 years before all of the fund's investments will be liquidated, sometimes even longer. Money will only be distributed to you as the venture capital fund liquidates these individual investments. There's no easy way for you to get your money back and there's typically no market for you to sell your limited partnership interest.

2. You'll be required to qualify as an “accredited investor.” For an individual, this means you must either have a net worth (or joint net worth with your spouse) in excess of $1,000,000; or have income exceeding $200,000 in each of the two most recent years; or joint income with your spouse exceeding $300,000 for those years; and a reasonable expectation of the same income level in the current year. Some funds have even higher net worth thresholds. If you're unable to meet the fund's investment criteria, they won't accept your investment.

3. The fund will require you to make a sizable upfront investment coupled with a substantial commitment for future investment. Most funds require, at a minimum, a $100,000 up-front investment with a minimum commitment in the $500,000 to $1,000,000 range. These numbers vary greatly depending on the size of the fund and the experience of the venture capitalist, however, they very rarely fall below these thresholds. The remaining bulk of your commitment will be tapped by the venture capital fund over a period of four to six years known as the "drawdown" period.

4. Investing in emerging technology companies is exceptionally risky and there's a strong possibility that a number of the venture capital fund's investments will be worthless and that none of these investments will see significant returns. The risk of losing all of your investment is higher when investing in a venture capital fund than when investing in public equities. However, it's probably lower than if you invest directly in companies as an angel or angel syndicate. The reason for this is twofold: You'll have exposure to a larger number of potential and actual investments through a venture capital fund; and the venture capitalists are theoretically better at identifying emerging trends and companies that are good bets than angels or angel syndicates.

Now, if you meet these criteria, can afford to have your capital locked in for a long period of time, and don’t mind the risk of substantial losses, the potential benefits are substantial--annual returns can often reach up to 30 percent for successful venture capital funds.

If you decide to pursue investing in a VC fund, you'll be given a private placement memorandum that describes the fund's objectives, the experience of the venture capitalists and the terms of your investment. It also includes a comprehensive “risk factors” outline that provides extensive detail on the various risks that you'll be assuming. You're also given the subscription agreement you must complete to make your investment and a copy of the limited partnership agreement that will govern the legal terms of the fund.

Familiarize yourself with these legal terms and consult with your attorney and other professional advisors before you pull the trigger. Bear in mind, the terms of the limited partnership agreement are typically not negotiable. This makes a certain amount of sense since the venture capitalist fund will usually have 20 to 30 different investors and may talk to hundreds of potential investors. These investors commit at different times and commit different amounts of money, so it would be extremely time-consuming and arduous to negotiate separately with all of them.

Now, if you were going to commit for a substantial percentage to the fund, then you'll have more latitude on terms and conditions. However, the typical individual investor is investing a relatively small amount when compared to the public pension funds and other large institutions investing and, consequently, he/she has relatively little bargaining power.

Fortunately, the terms of venture capital funds don't vary much from “market” rates that have evolved over the last 20 to 30 years. This can make it easier for you because you can simply check to see if the terms you're being offered are in the market range.

A few of the most common economic terms are the management fee, the carry, and reinvestment rights. Typically, governance rights for limited partners in venture capital funds are minimal.

The management fee is the lifeblood of a venture capitalist. This is the money that they live off of from day to day. Usually, the management fee will be a percentage of committed capital. That is, the total capital that everyone has committed to the fund, not the capital the fund has actually drawn down.

Traditionally, this fee has been 2 percent but anything from 1.5 to 2.5 percent is common, depending upon the size of the fund. With a larger fund, the percentage may be lower and vice versa for a smaller fund. This fee is taken annually and can add up relatively quickly. For example, if the fee is 2 percent, on a $200,000,000 venture capital fund, the venture capitalists collect $4,000,000 a year for 10 years-–or $40,000,000. And this is completely independent of whether they make good investments. Occasionally, the management fee will be capped at actual budgeted expenses or will scale downwards to reflect the fact that more work is required during the funds early years; however, a flat percentage is the norm.

The carry is the second form of compensation for venture capitalists. However, unlike the management fee, the carry is directly tied to success. The carry is the percentage of the fund's profits that the venture capitalist gets to keep, typically 20 percent. Often, the investors are guaranteed some ordinary rate of return on their investment (eg, 6 percent or 8 percent) that the fund must first deliver before the carry will kick in.

However, the latter distributions will be tiered up so that the venture capitalist ends up with 20 percent of all profits. Occasionally, there may be some deviation from the 20 percent figure, but this is rare. One thing to look for is whether the fund looks at the profits of the fund as a whole or on the profits from each individual investment. If the former, there's often a “clawback,” so that if an early portfolio company has a home run but all the rest are losers, you'll be able to take back the excess profits that are distributed to the venture capitalist.

Reinvestment rights are the right of your venture capitalist to take profits from early successes and reinvest them into new investments rather than pay them out to you and the other limited partners. This may be a good thing for you because it means you have more capital at work and, in a sense, this is free to you since the management fee doesn't apply to reinvested money. On the other hand, it may be a good idea to take some money off the table. Some form of reinvestment right, at least for the first few years, is relatively common. Just make sure you understand what it means to you.

The next part of this series will look in detail at angel investing and its important characteristics, including typical legal and business terms.
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Tuesday, June 23, 2009

No Appreciable Knowledge of Computers

An interesting historical artifact discovered by Steve Blank. Apparently, in 1956, Fred Terman (then Stanford's Provost) asked Bill Hewlett for help figuring out these new things called computers. Bill's response letter shows just how exotic computers were at the time
I have no personal knowledge of computers nor does anyone in our organization have any appreciable knowledge.

How times have changed. Click Here to Read More..

Tuesday, May 19, 2009

The Stages of Venture Capital Investing

The following is Part 2 of my five-part series on the roles of angel investors and venture capital investors in emerging technology sectors with explosive upside potential, such as the nanotech, cleantech, biotech, information technology and new media sectors.

In Part 1, I gave a general overview of the playing field. Below, I examine the stages of an emerging growth company’s lifecycle and the types of investment that it hopes to obtain at each relevant stage.


Many investors are confused by the differences between angel and venture capital. This isn't surprising; the categories are overlapping and are used inconsistently.

However, there are some broad generalizations that can be drawn, typically based on the timing of the investment and the purpose of the investment in the company’s lifecycle. Depending upon the timing, you can draw some basic conclusions as to the type of investor that will be involved (e.g. single angel vs. angel consortium vs. venture capitalist).

And, in each category, you can glean the form the investment will take (e.g. common stock vs. convertible debt vs. preferred stock) and the size of the return investors can expect. That is, if there's a return--very few private emerging growth investments are actually a success. More below the fold.

Seed Round

The earliest investment stages are usually characterized as seed rounds, proof of concept investments or angel investments.

These investments usually don't occur until after the target entrepreneur has tapped out his friends and family in what's usually called a “friends and family” round.

The money you invest is intended to allow the founders of the company to do their initial research, to complete the initial programming or to apply for the initial patent(s). Companies at this stage usually don't have a saleable product and don't have very many employees, other than the founders/inventors.

Traditional venture capital funds very rarely invest in seed rounds. Rather, seed investors typically consist of angels that is, wealthy individuals or groups of individuals that are willing to invest their own money and take the extreme risk involved in making equity investments into companies that often only have a good idea.

Occasionally, a seed investor may be a publicly or privately funded incubator established to help entrepreneurs or scientists get their ideas off of the ground.

In the seed round stage, the amount of the investment is typically small, say $100,000 to $500,000, seldom more than $1,000,000. Also, the investor usually takes common stock in the company--the same stock that the founders get.

Alternatively, the investor will take a convertible note that allows him to have the protection of debt at the beginning but with the possibility of converting and receiving the upside of equity. Typically, the conversion will occur in concert with the closing of the next round of investment and will be at the same per share price used in the next round.

Often, you receive some sort of additional incentive for making a seed round investment such as a conversion discount or grant of warrants.

Investments at the seed stage are extremely risky and are subject to significant dilution when new investors come in during later stages. Consequently, angel investors look for returns of at least 10x their initial investment, and sometimes as high as 20x or 30x their initial investment.

Early Stage Venture Round

The next stage of investment is early stage venture capital. Investors usually aren't interested in making this type of investment until the company has a proven product and a business plan.

However, it isn't necessary that the target be profitable or even be producing its product. The funds invested will be used to mass manufacture the product, market the product, build a sales force and further develop the product.

Typically, these sorts of investments are made by early stage venture capitalists, larger angels or angel consortiums. Early stage venture capitalists and angel consortiums usually have smaller funds to deploy which makes them more suited to making the relatively smaller sized investments found at this stage of a company’s life.

In this stage, the amount invested is typically in the $1,000,000 to $5,000,000 range. The investors will almost always be purchasing Series A preferred stock of the target. This type of stock is superior to the common stock held by the founders and any seed round angel investors and will typically come with dividend rights, liquidation preferences, some form of anti-dilution rights and a right of first refusal on stock sales by the founders and seed round angels.

Often, the investors will also receive pre-emptive rights, redemption rights, drag along rights and other rights and preferences.

Investors at in early stage investments will typically look for returns of at least 5x their initial investment and would gladly accept higher returns.

Growth Stage Venture Round

After the Series A round, there may be multiple additional rounds of equity financing. These types of funding are often called growth capital or mezzanine financing.

Usually, the company seeking this sort of investment will either be close to profitability or will have a clear path to profitability and the funds are meant to allow the company to expand its sales force and marketing efforts and ramp up its revenue growth. The money may also be used to develop additional products or to research expansion ideas.

These investments are usually made by the larger venture capital funds and the amount invested can range from $1,000,000 to $25,000,000 or higher, depending on the company and the market opportunity.

The investor typically will receive additional rounds of preferred stock--for example, Series B or Series C preferred stock--and each successive round will generally have superior rights and preferences to the prior rounds.

Investors at this stage may still look for 5x investment returns, but depending on the opportunity and the trajectory of the company, may settle for 2x or 3x returns.

Bridge Round

Occasionally, investors will be willing to invest bridge capital into a company in the growth phase of its life cycle, or one that's on the cusp of the growth phase. This investment takes the form of debt that “bridges” the gap in funding between rounds of venture capital financing.

These investments range in size depending on the company and the market opportunity and they're made by all types of investors, depending on the size of the investment. The lender may be an existing investor in the company or it may be a new angel or venture capital fund that's contemplating making the follow on round.

Usually, the debt will be represented by a convertible note that will automatically convert into the next round of preferred stock, sometimes at a discount. Also, investors will usually want some sort of warrant coverage to provide equity upside in the deal.

Investors at this stage expect a blended return that takes into account the interest rate on the debt and the potential value of the equity. These target returns vary greatly, but often move in the 12 percent to 18 percent range.

Buyout Capital Round

The final stage is characterized as acquisition or buyout capital. This is used by the company to purchase the assets or stock of other businesses that will then be absorbed into or added onto the target company.

The investors may be the company’s existing venture capitalists or it may be a private equity fund that's building out a platform in the company’s industry.

In the latter case, the investment may come with a right to purchase the company outright in the future. This type of financing also occurs when a company’s angels and venture capitalists start planning their exit strategy.

By putting together the right pieces it may make the company more attractive as an acquisition candidate or perhaps more eligible for an IPO.

In the next three parts of this article, I'll explore angel investing, angel syndicate investing and venture capital investing, in greater detail and I'll discuss the important characteristics of each mode, including typical legal and business issues.
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Friday, May 1, 2009

When Venture Capital Fits - Part 1

Below the fold is Part 1 of an article I recently wrote for the New Tech Investor e-newsletter. Many thanks to the publisher, Gregg Early, for the opportunity to write a longer piece. Stay tuned for parts 2 through 5.
When Venture Capital Fits - Part 1

Nanotechnology is a catch-all term for the sciences of the super small. It's notable not just for the amazing discoveries being made in labs, but in the ways in which these “pure science” initiatives are being commercialized in the cleantech, biotech, medical device and information technology sectors.

The world of nano has crept into each of these sectors with the potential for revolutionary technical advances and explosive commercial growth.

One clear example of this is Sapphire Energy. This cleantech company is working on squeezing high-octane fuels from algae.

They're doing this by using mesoporous nanoparticles to extract crude oil from living algae without harming the plants in the process. These sponge-like materials are capable of collecting only small amounts of oil, but they're deployed in very large numbers.

Once the collection process is completed, a catalyst will be used to produce biodiesel and bio jet fuel. Sapphire already has tested its bio jet fuel with Continental and JAL.

According to Sapphire, it's ramping up production estimates to 1 million gallons of algae-based diesel and jet fuel per year by 2011. By 2018, Sapphire is expecting to produce 100 million gallons per year.

By 2025, that number could reach 1 billion gallons per year, which would represent approximately 3 percent of the US renewable fuel standard. That's an exciting emerging growth prospect.

But how do individual investors get involved in pools of innovation such as Sapphire? You could turn to public equities. However, you may find that public companies aren't ideal for investing in innovation, especially as pure nano plays.

This is not to say that public tech companies aren't doing some important work; they are. But for more stable, mid and large cap public companies, diversification tends to dilute pure tech returns.

It makes a lot of sense from a risk management perspective for the public company to have its eggs in more than one basket. If any one product or product line is a failure, the others can make up for it. But, the flip side is that if one product or product line has an explosive success (for example, because of the successful implementation of a nanotech) this success will be muted by the other product lines.

If you're looking for pure exposure to nanotech, this isn't an ideal situation. If you're looking to invest in pure nanotech plays and then hedge against any nanotech exposure risk by owning companies in other industries or by making investments in other asset classes, a large public technology company isn't your best choice.

Another problem with investing in a public nanotech company is that often the explosive run up in equity valuation has already occurred. Typically, exponential valuation increases happen between the founding of a company and its various private equity rounds and then again during and immediately following the company’s initial public offering.

When investing in a private early stage company, it's possible to invest at a much lower equity price, albeit with much higher risk. As an aside, this concept is essentially the backbone of the traditional venture capital industry business model: Invest in a relatively large number of early stage companies and let the small number of explosive successes balance out the large number of failures. To put it very generally, 1/3 will fail, 1/3 will break even and 1/3 will generate returns orders of magnitude beyond your initial investment. In the aggregate, your investments are a success.

It's factors like these that drive many investors seeking exposure to nanotech and other emerging technologies to invest in private emerging growth companies.

For example, Sapphire was founded in 2007 and is already one of the most well funded companies in the sector, having raised more than $100 million from Bill Gates’ investment firm Cascade Investment, as well as ARCH Venture Partners, Wellcome Trust and Venrock.

Ways To Play Private Equity

Generally, there are three ways to get into the private equity market:

1) invest in seed stage or early stage companies as an individual angel;

2) invest in early stage companies as part of either a formal or informal syndicate with other angels/early stage venture capitalists;

3) invest as a limited partner in a venture capital fund that will then invest in several early stage or growth stage companies.

There are distinct differences between these three strategies. The first mode, investing as an angel, is a solo activity. It's up to you to identify the opportunity, negotiate the terms of the investment and bear the entire amount of the investment.

Since angel investments are usually made very early in the company life cycle, the associated risk is very high. That is, most angel investments don't pay off, but the rewards can be huge.

The second mode, investing as part of an early stage syndicate, is a group activity. No particular investor is in charge and democracy is usually the rule of thumb.

Using syndicates allows an individual investor to take a smaller piece of a larger number of companies, but it also carries with it loss of control and oversight over the investments. Syndicates can also be a great source of deal flow and a ready advisory panel that can be a sanity check to the investments.

The third mode, investing as a limited partner in a venture capital fund, is completely hands off. The investor is investing in the vision and/or track record of the venture capitalist and will depend on the venture capitalist to make and manage all investment decisions.

It's crucial that you match your investment goals with VCs sharing similar goals. For example, an investor that wants to maximize exposure to nanotech and its commercialization wouldn't want to invest with a generalist VC or a VC focused on Web 2.0, SaaS or cloud computing sectors.

The next part of this series will explore the various stages in a private company’s life cycle and the related forms of investment a company will hope to receive at each relevant stage.

In particular, I'll examine the differences between seed stage, early stage and growth stage and what types of money is being invested during each phase.

Parts three, four and five will take a closer look at the three modes of investment discussed above, angel investing, syndicate investing and venture capital investing, and each will look in detail at the important characteristics of the mode, including typical legal and business terms.
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Thursday, April 23, 2009

Tuesday, April 21, 2009

Both You And Your Job Have Been Moved to India

A few weeks ago, I noted in a quick blog post that IBM has a new method of outsourcing -- not only are they moving the job overseas, they are also moving the people.

That is, IBM is apparently accepting volunteers to move to India and other emerging growth countries. But (as always) there are catches: 1) if you do not volunteer there is a decent chance your job will be outsourced anyway (but without you); and 2) you will be paid the prevailing local wages (although IBM is apparently offering "financial assistance to offset moving costs, ... immigration support, such as visa assistance, and other support to help ease the transition of an international move.")

When I initially heard about the program, I have to admit I was skeptical as to whether it would appeal to IBM employees. However, the other day I had coffee with an ex-IBM guy that still has many friends at big blue. His (admittedly anecdotally based) opinion is that many of the eligible IBM employees look at this offer as a great opportunity. Typically, the employees interested in accepting this offer are natives of the countries that they would return to -- and they still have extensive family and business networks in place. Further, I am told that the "prevailing local wage" is actually quite comfortable and often provides for a superior standard of living to that affordable in the States (assuming standard of living is measured in things like having a gated building, a driver and a housekeeper. Having been to India multiple times, I might have different personal benchmarks.) So I guess my skepticism is unwarranted -- and honestly, the more I think about it, the more I can see the appeal.

The only remaining question is what to call this program -- outsourcing squared? Reverse outsourcing? I'm open to suggestions.

सौभाग्य Click Here to Read More..

Monday, April 20, 2009

Homeless Guy Says, "I'm a PC"

Unless you have been living in a box, you have probably come across Microsoft's new "Laptop Hunters" ads -- where Microsoft gives folks cash and tells them to go find a computer they like. And, coincidentally, they always pick a PC. These ads, along with Apple's "I'm a Mac" ads have been especially prevalent during this weekend's NBA playoff games.

Anyway, I got a kick out of this send up of the Laptop Hunter ads which features a homeless guy. My favorite line is when he says about the PC: "I'm poor, but I'm not retarded. These computers suck." Enjoy!

(More original blog postings coming soon).

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Tuesday, April 7, 2009

4 Bits of Advice for a Biotech Start-Up

The biotech industry is not for the faint of heart -- especially in an early stage or start-up company. Time frames are long, costs are extraordinarily high and there is no guaranty of success. All of these risks are magnified in today's rarefied air of non-existent IPO markets and schizophrenic M&A exit opportunities.

Dow Jones recently hosted a webinar advising small biotech companies on how to navigate these treacherous waters. In his recent blog post on the WSJ Venture Dispatch, Jonathan Matsey mentions four nuggets of advice from this webinar and gives some good additional gloss. Below are summaries of the 4 points and some of my own thoughts -- please see Jonathan's original blog for his full color.

1. Think globally. It is often possible to generate revenues internationally long before the United States FDA has approved your drug/device. I have seen clients find additional revenues in the more traditional European markets as well as the emerging Asian markets.

2. Partner up -- but make sure you don't give away the keys to the car. Depending on the strength of your vision and the potential of your product, carefully consider the terms of your out licenses and any associated rights of first offer or first refusal you give to your partners. This is a tightrope that can be tricky to walk -- the immediate fix of revenues versus the long term potential of your product -- and negotiating a partnership with the big boys will require some thorough introspection.

3. Nurture your champions. Once you have a partnership with big pharma/big device/VCs make sure you develop and nurture internal champions that understand your research/product and are willing to go to bat for you. Keep them in the loop. If it makes sense, get them involved in your advisory board or even your actual board. Let them carry the ball for you by making them feel like part of your team -- that means they need to know the play call!

4. Get your name out there. The only way you will find partners and capital is for them to know who you are. In complex fields such as biotech, where sometimes even your own employees don't entirely understand what you do (other than the lead scientists and/or founders, of course), you have to self promote. Go to the important trade fairs. Present where possible. Have a presence at forums/symposiums. Get involved in your local bio group. No one can invest in you or partner with you if they don't know who you are.

Come to think of it -- these bits of advice are equally valid to any start-up company, no matter the sector. Click Here to Read More..

Thursday, April 2, 2009

How to Fail: 25 Secrets Learned Through Failure

I recently came across this fantastic post by Taylor Davidson on his blog, Unstructured Ventures. In it he lists 25 different mistakes he has made, the lesson that can be learned from each and an illumination of each lesson based on context and examples. It is a great read full of intelligent advice.

Note: if the text in the slide presentation below is too small -- try either clicking on the link at the top of the presentation or click here to view it in pdf format.

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Wednesday, April 1, 2009

Angel Investing in 2008: Numbers Even/Dollars Down

Everyone knows that 2008 was a bad year for public equities and for most sectors of venture capital investment (see my earlier blog post here). But how was 2008 for angel financing?

According to this report from the Center for Venture Research, while the dollar value of angel investments contracted 26.2% in 2008, the total number of investments remained relatively stable with only a 2.9% decrease from 2007.

The net effect of these two trends is that the average deal size for angel investments fell by 24%. Angels were still doing deals in 2008, but they were committing smaller amounts of capital.

The report breaks out angel investments by sector and notes that healthcare/medical devices represented 16% of angel investments in 2008, followed by software at 13%, retail at 12% (including web retail), biotech at 11%, industrial/energy at 8% (including cleantech) and media at 7% (including social media).

The report has lots of other interesting statistics, but one final one that jumped out at me is the following -- angel investors invested in only 10% of all investment opportunities brought to their attention in 2008. This is down from 23% in 2005. Clearly, not only are angels investing less, but they are being more picky. A possible positive spin on this statistic is that, since the number of investments has remained constant, this must mean that many more people are looking for angel capital -- a sure sign that we are experiencing an innovation renaissance. Click Here to Read More..

Tuesday, March 31, 2009

Why Can't I Take My LLC Public?

Why shouldn't I start my new business as an limited liability company (LLC) instead of a corporation? My uncle tells me that all the savvy business folks use LLCs now.

I have heard some variation on this question many times over the years. The answer to what sort of entity you should use when forming your business is a complex one that will depend on many factors and you should certainly consult your accountants, lawyers and tax advisers (and probably not your uncle, unless he happens to be one of the foregoing).

However, as I have posted in great detail before, one thing I can say with a fair amount of certainty is that, if you intend to raise venture capital, you should almost never use the LLC form. There are many reasons for this -- most of which I discussed in this prior post. But one point I made deserves some additional flavor. I noted, almost in passing, that
it is not possible to do an IPO with an LLC. Any LLC that wanted to go public would be required to first convert to a corporation anyway with potentially very adverse tax consequences

I recently was asked why it is "impossible" to do an IPO with an LLC. This is a good question, as there are certainly no federal or SRO prohibitions on doing an initial public offering as an LLC. In fact, there are publicly traded LLCs -- Fortress and OchZiff come to mind. More below the fold.

However, LLCs are creatures of state laws and it is the state laws that often make it impossible (or exceedingly difficult) to do an initial public offering of an LLC. For example, there are states that do or did not allow the free exchange of LLC interests. Also, there are states that require an LLC to dissolve when a member dies and states that require all LLCs to dissolve after a set period of time, ex. 30 years. All of these terms would make an IPO impossible without first converting the LLC to a different entity/state.

These laws are in flux and often a state with a more antiquated LLC statute will update it. Unfortunately, the existing LLCs will still have the old terms in their operating agreements. Sometimes an amendment will be possible, it depends on the terms of the operating agreement and votes required, but it could be tax painful or logistically difficult.

Even if you formed your LLC in a state that has an IPO friendly set of statutes (Delaware comes to mind), in my experience an IPO remains practically impossible because of the underwriters. Underwriters do not want any hair on an offering -- anything that could give a potential investor pause. Often, an underwriter will force a company formed outside of Delaware to convert to Delaware just for purposes of the IPO. To try to go to market with an exotic IPO equity like an LLC membership interest is simply a non-starter for anything that is already risky, i.e. a tech start-up. In today's IPO market, it is hard enough to get underwriters interested in a start-up IPO, it would take extraordinarily exceptional circumstances to convince them to underwrite an LLC.

My final thought is, if you are founding a company that hopes for venture capital, why ratchet up your level of difficulty from the beginning? You will have enough business challenges -- why give yourself structural challenges too. If you know you are creating a company that will need VC and you hope in your heart of hearts to someday do an IPO, why not instead take the path of least resistance when you form your company and use a C corporation? (Again, this is not to say that LLCs are not VERY useful in many other circumstances.)
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Monday, March 30, 2009

Has Venture Capital Matured?

Have the information technology/web industries matured to the point that traditional venture capital no longer makes sense for them? More below the fold.

In a recent blog post, Fred Wilson discusses the rather dismal average returns seen in venture capital over the past 10 years (especially once you factor out the late 90s bubble and Google).

In his post, he muses that
entrepreneurs in the web sector have done a great job of figuring out how to build companies on much lower capital needs and we also have a vibrant angel and early stage (pre-VC) market developing. So it may be that the real problem is that there is simply too much money looking to get put to work in the VC asset class (certainly that is true in information technology)

My belief is that the relatively lower venture capital returns being seen in the IT sector are emblematic of a maturing industry. Many of the technology fields that powered the VC boom over the last two decades are now relatively mature industries. The PC, the internet, cell phone technology, Web 1.0, even Web 2.0 in many ways. It is precisely because the industry has matured that web/IT startups need a lot less capital to get going. It has become very cheap to buy computers, host servers etc. And the ubiquity of the internet and web 2.0 has made getting the message out about a product/application easier and cheaper than ever (if you can overcome the signal to noise issues).

I think that the rise of the micro VC niche is more a symptom than a cause of this. Companies, need less money to get traction in the IT sector and so financing sources have evolved a model that allows them to make money by making smaller investments. However, the flip side of this is that the mega funds have gotten so large that they can't put enough capital to work in the really disruptive corners. In addition, competition among the mega funds for the few start-ups in this sector that both are exciting and need a lot of capital drives down returns. There will always be room for the talented VCs in the IT sector, but the shakeout seems to already be under way.

As I have posted before, there are simply too good of returns that can potentially be realized in other less mature sectors (cleantech/biotech/nanotech) and other less mature geographies.

For example, the trend of many VCs in the US moving away from traditional computer and information technology and into cleantech, biotech and medical devices.

Moreover, right now home run returns can be visualized in India and China. (Although very few have materialized to date.) And investments are often being made in sectors that sound foreign to the VC world of the last 9 years, such as in education, hardware manufacturing and infrastructure. (Much different than web 2.0, SaaS and the cloud). However, when you take into account the massive and growing middle classes in India and China, these investments have the potential for the kind of explosive growth that a VC is looking for.
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Thursday, March 26, 2009

The Nano Song

And thanks to Nanotechnology, they all lived happily ever after ...

An inspired explanation of the fundamentals of nanotech. I hope you enjoy this as much as I do.

The Nano Song from nanomonster on Vimeo.

(It improves after repeat viewings...) Click Here to Read More..

Wednesday, March 25, 2009

What is My Company Worth? Be Careful How You Answer...

What is my company worth? The answer to this question is key to successfully finding sources of equity and completing the investment process. However, this question is often one of the most difficult ones for an entrepreneur to answer. For more on this, please see below.

Determining a proper valuation of a start-up company is especially tricky in the early stages -- that is, the friends and family, seed and/or angel rounds of funding. I recently posted extensively on angel funding and how to obtain it here, here and here.

There are two dynamics contributing to this trickiness. The first I like to call the preservation ethos -- that is, the understandable fundamental desire of the founder to preserve his share of the company. If the pre-money valuation of the company is too low, the relative portion of the company purchased by the new investor will be larger -- and, consequently, the founding entrepreneur will own less of the company. A simple example, if a company is valued at $500k and it raises $500k of new money from friends and family then the post-money valuation of the company will be $1mm and the founder will only own half. In a company where several successive rounds of equity financing are contemplated, this may be an unpalatable situation for the entrepreneur/founder.

The second dynamic is what is known as valuation creep. Sometimes this is the result of a conscious effort by the founder to avoid dilution by setting artificially high valuations in early rounds. Sometimes this is simply the result of ignorance or exuberance -- i.e. if I tell everyone my company is worth millions of dollars then maybe they will be more excited to invest before it quintuples in value. The result is an unsustainably high valuation in early financing rounds.

I use the word unsustainable because in later rounds (for example an early-stage Series A round sponsored by a venture capitalist) a professional investor using proper valuation metrics will either refuse to invest at your inflated valuation or will require the next round to be a down round at a lower -- and more supportable in the eyes of the VC -- valuation. Each of these outcomes is less than ideal -- either you will be unable to raise needed new capital or the new capital will be even more dilutive than usual. It is more dilutive than usual because a down round not only is dilutive in a relative sense but also an absolute sense. In a normal up round, you are diluted relatively because additional shares have been sold, but on the other hand, you are usually better off because if the valuation per share has increased, your shares are now theoretically worth more. The value of your investment has increased. However, in a down round, not only are more share being issued (relative dilution) but they are being issued at a lower price -- which means your existing shares are now worth less and your investment is now in the red. This hurts both the founder and the friends and family/seed/angel investors that collaborated in the valuation creep.

An additional problem with setting too high a valuation in the early rounds is that this valuation will likely become a fair market value floor for option purposes -- meaning that the company may be unable to grant options with a strike price significantly less than the price in the last equity round. Stock options are an important tool for attracting and retaining talented personnel in the start-up environment and, consequently, it is important to keep in mind the impact that a financing round may have on future employee retention.

So you may ask yourself, what is the secret to avoiding valuation creep while also preserving founder value? The answer is, there isn't one. It's a matter of "touch" and "feel" and striking an appropriate balance between the various constituencies. In the majority of start-up companies, obtaining a proper professional valuation is neither efficient nor feasible. This makes the entire valuation process an educated guess for a start-up -- a guess driven more by external factors than any quantitative exactitude. The proper number is one which can be agreed upon by the relevant parties and the real risk is that the friends and family or angel investor is not experienced enough to understand the dangers associated with too high a valuation. The trick is to pick a reasonable valuation and then run with it -- there really is no magic to the process. At a later stage, the professional investors will perform a proper financial analysis and determine what valuation they think you can reasonably justify -- and you can argue with them then.

One final point -- this discussion assumes that the early investors will be taking equity in the company. This is not always the case and, quite frankly, I usually recommend that angel investors take convertible debt. For more on this, stay tuned. I have been working on a blog post analyzing what I think is the best way to handle angel investments -- I hope to post it next week.
Click Here to Read More..

Tuesday, March 24, 2009

4 Thoughts on Obtaining Venture Capital

The "MarketingBlagger" recently jotted down some good advice discussed on a panel made up of women entrepreneurs, angels and venture capitalists. It was a pithy enough list that I wanted to share it with you here.

The panellists included Anna Sofat from Addidi Business Angels, Shaa Wasmund from, Judy Gibbons from Accel Partners, Andrea Cockerton from Mudhut, Julie Meyer from Ariadne Capital and Bill Morrow from Angels Den.

-- When pitching for funding, make sure your presentation delivers “immediate grasp and immediate gasp” Andrea Cockerton, Mudhut. In other words, you need to clearly explain what your proposition is and then how it is possible to extract the commercial value.

-- Explain how you can scale up your business. An investor will only back your venture if it they can see that it will clearly cope with strong growth. If your business model requires your every attention in person, it will not be able to support rapid growth and therefore the return will be harder to come by.

-- Have a strong team in place with some industry experience. Those companies that performed the best on the evening had real industry expertise in their executive team, which is something to bear in mind.

-- When pitching, you can more or less leave out the financial predictions from your presentation. Pretty much all of the panellists agreed the figures are generally pie in the sky and investors are much more likely to invest in a person and a business idea. Click Here to Read More..

Monday, March 23, 2009

How to be an Angel Investor

Ever wondered if you have what it takes to be an angel investor? Or have you dabbled in angel investing without a pre-determined method? Alternatively, are you seeking angel capital and would you like insight into the angel investing process and mindset?

If you answered yes to any of the foregoing questions, you may find the below presentation helpful. It is a combination audio file and slide deck covering the subject "How to be an Angel Investor." The deck was prepared by Naval Ravikant and Babak Nivi, the guys from Venture Hacks, for a Y Combinator conference. The audio file contains a recording of Naval and Nivi's presentation and is synched to the deck.

It is a relatively long piece - almost 30 mins -- however, the content is fantastic and I highly recommend you give it a listen.

Click Here to Read More..

Wednesday, March 18, 2009

To Get VC, Lose the Jargon and Catchphrases

In the venture capital and start-up world, you frequently hear entrepreneurs and incipient financiers using the word du jour. The buzz word. What they believe is the "it" or the "new new" thing. It is almost as if they believe that, much like Ali Baba, if they merely utter the magic words, the door to the treasure cave will open.

Whether the current catchphrase is Web 2.0 or cloud computing, by the time it is widely recognized as a catchphrase in the MSM it is too late. Too many times I have watched a budding entrepreneur bang the drum of a long over-done buzz word and watched the potential venture capitalist visibly recoil after each stroke. As I mentioned in my earlier post "Five Keys to Raising Venture Capital":
Anyone that is a real source of funding is sophisticated enough to see through a sales routine. They may not call you out on your "marketing" but they certainly won't invest. Answer questions directly and when you don't know the answer, admit it. Don't tell the investor or his advisers what you think they want to hear. Trust me, it is more obvious than you think. Also, don't over play the buzz words. If they are buzz words, the novelty has already worn off. Seriously, Web 2.0/3.0 just does not get people excited anymore. Explain what you are doing and how you are going to do it.

In a great article last week, James Urquhart of CNET made a very similar point in his discussion of cloud computing. He said:
I've had a few discussions with venture capitalists of late regarding the assignment of the "cloud" label to start-ups pitching everything from hardware to--believe it or not--downloadable software clients.
It seems that just about every pitch these days is for "cloud computing," and the folks with the money are getting a little weary of it.

I echo his sentiments and urge entrepreneurs to put more effort into explaining their business proposition in clear and easy to understand English. Jargon is rarely the answer. Click Here to Read More..

Tuesday, March 17, 2009

Does Innovation Emerge From Recessions?

It is beyond question that the economy is in a recession and that job losses abound. One common theme that has emerged from the many recent articles and blog posts discussing our economic predicament is the intuitive notion that job losses force innovation and entrepreneurship.

I discussed this theme in detail in my post "Does Recession = Boom Times for VCs and Entrepreneurs?" and noted the recent New York Times article discussing the demise of Venture Capital (a subject I have also discussed recently here, here and here) which concluded:
If there is a silver lining, the large-scale downsizing from major companies will release a lot of new entrepreneurial talent and ideas — scientists, engineers, business folks now looking to do other things ... There will be a lot of forced entrepreneurship that will lead to innovations.

What is even more interesting to me is whether there is any historic support for the intuitive notion that great disruptive companies are born in the crucible of a recession.

I recently came across a nice visual representation that at least provides some anecdotal support for this. It shows the various down cycles in the US economy over the last 60 years or so and identifies some of the major innovating companies that were formed during each period. Although not analytically rigorous, it is an interesting visual tool.
Click Here to Read More..

Monday, March 16, 2009

A Venture Capitalist's Anti-Portfolio

Venture capitalists are no different than other types of investors when it comes to taking ownership of their failed investments. As they say, success has many fathers but failure is an orphan.

In a lot of ways this makes sense. It is human nature to assume that a successful venture capitalist must have vision and skill and the successful ones will be able to raise subsequent funds. It is precisely for this reason that the venture capitalists perform such fulsome business diligence on their potential targets (which I discuss in more detail here). If a particular investment does not work out, the VC can at least demonstrate that the financial analysis supported the investment.

What is perhaps even more difficult to swallow for a venture capitalist is when they miss a potential opportunity entirely. That is, when they look the young Steve Jobs in the eye and say, "Sorry, Steve -- we're going to pass on this Apple thing. We just don't see the sort of returns we need."

Refreshingly, one venture capital firm -- Bessemer Venture Partners (one of the oldest continuous VC firms around, c. 1911) -- has owned up to exactly that, among other things. The link below is a true list of the various opportunities that they passed on over their long and storied history. And yes, they told Steve Jobs no.

Here is the link. Click Here to Read More..

Sunday, March 15, 2009

I'm Back!


Sorry for the almost two straight weeks of dead air. My only excuse is that I had two consecutive long trips (one to LA and one to Peru) and have spent the last 3 days digging out from under a mountain of emails, DMs and voice messages. I also had the pleasure of pulling together my tax records.

However, I have been ruminating on a few things and should be back to my usual blistering posting pace shortly. Thanks, as always, for following my blog.

One more thing, for more frequent (and usually more mundane) updates, please follow me on Twitter by going here.

Hank Click Here to Read More..

Tuesday, March 3, 2009

VIPEs -- Everything Old is New Again for Venture Capital

If you are looking for what's hot in venture capital investments, look no farther than VIPEs. All of a sudden, I am seeing a number of VIPE deals either being done or being talked about. Although I am only a single data point, I am at least seeing a trend.

What is a VIPE you may ask? Well, I am glad you asked. More below the fold.

With IPOs, mergers and other traditional exit strategies on a sharp decline, particularly in the tech and biopharma industries, enterprising venture capitalists have had to adjust their expectations and have been looking for opportunities to invest in already-public companies that are dramatically undervalued as a result of the market downturn. These public companies, unable to obtain credit on favorable terms and faced with the market’s growing hostility towards secondary offerings and other more conventional types of financing, find themselves in dire need of capital in order to execute and grow their business plan. As a result, struggling public companies and eager venture capitalists have turned to VIPE financing transactions, that is Venture Investment in a Public Equity.

A VIPE is very similar to the more common PIPE transaction (Private Investment in Public Equity) -- an investor is buying shares of a public company, but the investment it is not made through a registered public offering. Instead, it is done as a private placement of some type, usually (for PIPEs) with the public company on the hook to do a public offering of the shares in the future.

In a typical PIPE transaction, the PIPE investor is focused on the trading volume and liquidity of the stock of the public company and has a short term horizon in which to sell and turn a profit. A VIPE transaction, on the other hand, is more often made with a longer term in mind, say two to three years or more. The venture capital firm is willing to invest in a public company, instead of its usual private company asset class, because of the potential returns the VC sees in the public equity long term. The heightened disclosure obligations of public companies make it an easy task for a venture capital firm to diligence a number of potential targets at a time, identify those which are sharply undervalued as a result of the current economic climate and/or have strong prospects for the future. The VC then make his investment at a 10-15% discount on market price -- typical of VIPE transactions.

A potential sticking point for some VIPE deals comes up in transactions where the VC, used to receiving the rights and protections typical in private placements of preferred stock (such as a board seat, rights protections, etc.), attempts to get the same sort of protection from the public company in which they are making their VIPE investment. Trying to work these protections into a VIPE transaction presents a host of issues with federal securities laws, listing requirements and general corporate governance directives, and require creative drafting and approvals.
Click Here to Read More..

Thursday, February 26, 2009

Venture Capital Up 5% -> If you are in India or China

Venture capital investments up 5%!!

For once a positive headline about the venture capital market -- Venture Capital Investing Up 5%. However, like much good news, the trick is to read the dek -- the increase in investments was OUTSIDE the United States and focused on emerging markets like India, the PRC and Israel.

On the one hand, this could be disconcerting news to US entrepreneurs. If the money is going out of the country, then it is not here to fund your project. On the other hand, in a practical sense this is good news for entrepreneurs. The VCs are still investing in projects. The trick is to provide the VC with the sorts of returns he is expecting. I give a lot more detail on these expectations here.

Right now, the home run returns can be visualized in India and China. (Although very few have materialized to date.) And the investments are often being made in sectors that sound foreign to the VC world of the last 9 years. For example, investments are being made in education, hardware manufacturing and infrastructure. (Rather than web 2.0, Saas, cleantech and the cloud). However, when you take into account the massive and growing middle class in India and China, these investments have the potential for the kind of explosive growth that a VC is looking for. When you think about it, many of the technology fields that powered the VC boom in the last two decades are now relatively mature industries. The PC, the internet, cell phone technology, Web 1.0, even Web 2.0 in many ways. Thus, the trend of many VCs in the US moving away from traditional computer and information technology and into cleantech, biotech and medical devices.

In my mind, the takeaway from this for a budding entrepreneur should be, "how can I innovate in a manner that has the potential to generate explosive returns?" If you can do this, there is plenty of money to be had. Click Here to Read More..

Wednesday, February 25, 2009

Crash Course in Venture Capital

Do you need a crash course in how to find venture capital funding for your company? Or perhaps just a refresher course? The deck below was prepared by Jason Mendelson, a VC with the Foundry Group and Mobius Venture Capital. It provides a good succinct primer on venture capital and echoes many of the themes on this blog. Enjoy! Click Here to Read More..

Monday, February 23, 2009

Hulu Declares War on Apple Pie, Puppies and Boxee

Just when the Boxee party started getting really good, Hulu had to come along and p*ss in the punchbowl. Apparently, Hulu is bowing to pressure from "content providers" and is blocking access to Hulu from Boxee.

I have written before several times about Boxee -- the revolutionary software that allows you to view internet based TV/movies seamlessly on your TV.

One of the features that makes it most useful, at least for me, is that Boxee allows you to stream the television content contained on sites such as Hulu or directly to your TV. This solves the "last mile" connectivity issue between my iMac (which has access to virtually anything via the internet) and my HDTV which has a big screen and great clarity but no access to anything on the internet.

Hulu provides internet access to, among others, the main Fox and NBC television shows. When you watch the show, Hulu inserts some commercials in show breaks. These commercials cannot be fast-forwarded through or skipped. The result is the same whether you are watching Hulu on your personal computer or whether you are watching Hulu on your TV set via Boxee. Either way you see the commercials. Consequently, it should not matter to the true content provider on what device the content is viewed. Either way the content provider receives its advertising revenue.

To me, this seems like a much better outcome than the alternative where the end user pirates the content from one of the myriad torrent sites and watches it for free and without seeing any commercials. Unfortunately, by blocking Hulu from Boxee, the "content providers" seem to be traversing the same path that the record companies cut in the late 90s. Rather than recognizing innovation and attempting to monetize it as it happens they are attempting to squash innovation in a vain attempt to control the medium. This may well prove to be folly. Click Here to Read More..

Sunday, February 22, 2009

Twitter For The Win

It looks like Twitter's run of good luck and good times will continue. To update my earlier post post on the subject, Twitter's actual venture capital raise was in excess of $35 million dollars. Twitter raised $35 million from new investors and, according to TechCrunch, several of Twitter's earlier round investors also bought their pro rata shares.

Twitter still has virtually no revenues and no real plan at this point on how to generate any. But hey, they have a huge and growing user-base and now they have a lot more money to spend on figuring out how to generate revenues.

You can follow me on twitter here. Click Here to Read More..

Wednesday, February 18, 2009

Maybe Microsoft Needs To Get Out More?

An excerpt from an interview with Microsoft mobile chief Andy Lees regarding Microsoft's newly announced product, "My Phone":

Q: My Phone does rhyme with iPhone. Were you wary of doing that, or was that part of your plot?

Lees: No, no. My Phone is a feature. It’s not even a brand, it’s a feature. I didn’t even notice it before you said it.

Q: You didn’t notice the rhyme? Oh, come on. You guys didn’t have deep internal discussions about the fact that it rhymed with the main product of one of your main competitors?

Lees: No.

Someone please buy the guys at Microsoft a rhyming dictionary.
(Thanks to John Paczkowski) Click Here to Read More..

Mark Cuban Wants to Fund Your Company (maybe)

Will Mark Cuban fund your company? You never know.

In a recent blog post, Mark Cuban committed to funding any entrepreneur with a proposal that met certain criteria. He called this commitment his own personal "stimulus plan" and stated that entrepreneurs can "lead us out of this mess."

To quote Cuban:

As I find businesses I like, I will use the email address you provide before you post to get in contact with you. There will be a standard agreement, you can take it or leave it. Once I have done the standard agreement, I will post it here for all to see. This will definitely be a work in progress. Maybe it leads to great things, maybe it leads to nothing. We will find out. I'm not going to claim a minimum or maximum amount or total I will invest. I'm not promising I will definitely invest anything. If nothing comes along that I think is viable, that's the way it goes. Hopefully I will invest in quite a few businesses that will lead to something more.

Here are the criteria:

1. It can be an existing business or a start up.
2. It can not be a business that generates any revenue from advertising. Why? Because I want this to be a business where you sell something and get paid for it. That's the only way to get and stay profitable in such a short period of time.
3. It MUST BE CASH FLOW BREAK EVEN within 60 days
4. It must be profitable within 90 days.
5. Funding will be on a monthly basis. If you don't make your numbers, the funding stops.
6. You must demonstrate as part of your plan that you sell your product or service for more than what it costs you to produce, fully encumbered.
7. Everyone must work. The organization is completely flat. There are no employees reporting to managers. There is the founder/owners and everyone else.
8. You must post your business plan here, or you can post it on, or google docs, all completely public for anyone to see and/or download.
9. I make no promises that if your business is profitable, that I will invest more money. Once you get the initial funding you are on your own.
10. I will make no promises that I will be available to offer help. If I want to, I will. If not, I wont.
11. If you do get money, it goes into a bank that I specify, and I have the ability to watch the funds flow and the opportunity to require that I cosign any outflows.
12. In your business plan, make sure to specify how much equity I will receive or how I will get a return on my money.
13. No multi-level marketing programs. (added 2/10/09 1pm)

If you are interested in getting some of Cuban's "open source funding" click on his blog link and apply by leaving a comment. More than 1300 people have already done just that. Click Here to Read More..

Monday, February 16, 2009

Employees vs. Consultants: What a Start-Up Should Consider

Should a start-up consider classifying its workers as consultants rather than employees? Generally this is a bad idea. However, it is common for a start-up to classify its founders or other employees as consultants in order to avoid withholding taxes from their (typically limited) pay checks. More below the fold.

The IRS does not really pay attention to your justifications for classifying a particular person as a consultant and filing 1099s. Instead, they are going to look at how much control the company has over the person you claim is a consultant. Too much control = not a consultant. This matters because, if the IRS determines that someone you have been treating as a consultant is actually an employee, then the company will have liability for taxes that were not withheld as well as potential liability for interest and penalties.

This is precisely the sort of issue that will give a venture capitalist an excuse not to invest in your business. These sorts of issues are pretty obvious during the diligence process and the VC will require that all of this is cleaned up before they entrust you with any of their LP's money.

A natural question would be -- what about my actual consultants? How can I tell and ensure that they will get the correct "consultant" treatment. To answer this, I have always used a 20 question test that distills the IRS rulings in this area, I have included in parenthesis the answer you want to hear if you want to classify this person as a consultant.

1. Is the consultant required to comply with your instructions as to when, where, and how the work is to be done? (No.)

2. Did you provide the consultant with training to enable him to perform his job in a particular method or manner? (No.)

3. Are the services the consultant provides integrated into your business operation? (No.)

4. Must the services be rendered by the consultant personally? (No.)

5. Does the consultant have the capability to hire, supervise, or pay assistants to help him in performing the services under contract? (Yes.)

6. Is the relationship between the consultant and your company a continuing relationship? (No.)

7. Who sets the hours of work? (The consultant does.)

8. Is the consultant required to devote his full time to the your company? (No.)

9. Does the consultant perform the work at your company's place of business? (No.)

10. Who directs the order or sequence in which the consultant works? (The consultant does.)

11. Is the consultant required to provide regular written or oral reports to you? (No.)

12. What is the method of payment - hourly, commission or by the job? (Fixed price, not-to-exceed, and/or milestone payments are generally standard for independent contractors.)

13. Do you reimburse the consultant for his business and/or traveling expenses? (No.)

14. Who furnishes tools and materials used by the consultant in providing services? (The consultant does. This includes workstation, internet access, etc.)

15. Does the consultant have a significant investment in the facilities he uses to perform his services? (Yes. The focus here is on the word "significant." Lots of employees have a home computer.)

16. Can the consultant realize both a profit and a loss from his work? (Yes-the consultant must assume risk based on whether you are satisfied with his work.)

17. Can the consultant work for a number of firms at the same time? (Yes.)

18. Does the consultant make his services available to the general public? (Yes. For example, the consultant should have business cards, stationery, invoices, and a business listing in the phone book.)

19. Is the consultant subject to dismissal for reasons other than nonperformance of contract specifications? (No.)

20. Can the consultant terminate the relationship without incurring a liability for failure to complete a job? (No. If the consultant works on a project or milestone basis, the consultant must deliver to receive payment for his efforts.)

You should note that no one of these factors is determinative. However, if you answered one or more of them incorrectly you should consider discussing the potential consulting engagement with your counsel. Also, when considering these factors, please note that your mileage may vary depending upon your situation and the state(s) in which you do business. Please consult an experienced employment lawyer if you are pondering a close call.
Click Here to Read More..

Sunday, February 15, 2009

7 Critical Factors for Obtaining Venture Capital

What are the seven critical business factors you should consider when you want to obtain venture capital funding? I came across the list below the other day and appreciated the no-frills business perspective. It was prepared by Garage Technology Ventures, a seed-stage and early-stage venture capital fund.

The seven critical factors are:

1. Compelling Idea

2. Team

3. Market Opportunity

4. Technology

5. Market Opportunity

6. Financial Projections

7. Validation

I encourage you to read the full post here. Click Here to Read More..

Saturday, February 14, 2009

Cleantech and Biotech as Growth Industries in 2009?

Will cleantech and biotech be the growth industries for small business start-ups in 2009? Cliff Schorer believes so and discusses his thoughts in the video below from Big Think.

What is perhaps counter-intuitive about his analysis is that the cleantech and biotech start-up sectors are the most capital intensive of the various start-up sectors. This would seem to make it harder to get going for an entrepreneur. (Although see this blog post by Mark Reiboldt on how to bootstrap a biotech or cleantech startup).

On the other hand, as I noted previously, these are precisely the sectors that have the best chance for stimulus funding, have seen the largest number of new venture capital investments and that play into the very large fund sizes that VCs have raised in the last two years. So, although picking these capital intensive sectors may seem like an "oxymoron" (to use Cliff Shorer's phrase) on the other hand it makes a lot of sense.

video platform
video management
video solutions
free video player
Click Here to Read More..

Wednesday, February 11, 2009

Five Keys to Raising Venture Capital

Raising venture capital is never an easy task. The target seems to always be in motion and you are subject to macro trends which are completely beyond your control.

With this in mind, below is a quick list of five things an entrepreneur should keep in mind:

1. No VC has ever invested in the perfect business plan. While the creation of your business plan is an important thought process for refining your ideas and anticipating challenges, it is nowhere near as important as actually implementing your business and/or proving your concept. You need to have a business plan to show that you understand what you are doing and what the challenges and risks will be, but without evidence of action, a business plan is not worth the glossy paper it is printed upon. Note -- angels WILL invest in just an idea/business plan, see point 2 below.

2. You need to know and understand the different types of capital that are available. There are significant differences between seed capital, early stage capital, venture debt and growth capital. There are also significant differences between angel investors, venture capitalists, strategic investors and private equity funds. Before you start pitching folks, make sure you know what you are looking for and whom you are looking to get it from.

3. Can you explain your business to a 5th grader? Most 10 year olds are savvy enough to understand the fundamentals of virtually every business. If you can't explain your business to a 5th grader, you should spend more time thinking about what the core of your business is. It always amazes me when a (potential) entrepreneur cannot explain his business to me in a way that fundamentally makes sense -- and, according to my wife, I am slightly more sophisticated than a 5th grader.

4. Don't BS people. Anyone that is a real source of funding is sophisticated enough to see through a sales routine. They may not call you out on your "marketing" but they certainly won't invest. Answer questions directly and when you don't know the answer, admit it. Don't tell the investor or his advisors what you think they want to hear. Trust me, it is more obvious than you think. Also, don't over play the buzz words. If they are buzz words, the novelty has already worn off. Seriously, Web 2.0/3.0 just does not get people excited anymore. Explain what you are doing and how you are going to do it -- see point 3 above.

5. Investors go with who they know. As an entrepreneur, if you don't already know potential investors, then you need to start getting to know them. Talk to your local incubator, present to some angels, meet professional advisors in your sector. You could even try commenting on relevant blogs. A pitch given via a warm introduction has a vastly superior chance of succeeding when compared to a cold call or a true elevator pitch.

Good luck! Click Here to Read More..

Tuesday, February 10, 2009

Top 10 Geek Business Myths

A list of the most common mistakes "geeks" make when starting businesses that hope to raise venture capital. This top 10 list was prepared by Ron Garrett way back in 2006, but it has some excellent advice for today's modern age and I have re-read it and forwarded it several times over the years. I don't agree with all of it, but it is a very useful conversation starter.

Top Ten Geek Business Myths Click Here to Read More..

Monday, February 9, 2009

The Future of Television

I have written before several times about Boxee -- the revolutionary software that allows you to view internet based TV/movies seamlessly on your TV.

Personally, I have my iMac connected directly into my HDTV (using a Mini DVI to HDMI converter). However, a few of you have asked me what to do if you cannot connect your computer directly to your TV.

One very promising option is to use the AppleTV. This is a $230 hard drive that connects directly to your TV. You just need to get it hooked into the internet. Boxee has a configuration that is designed for the AppleTV and apparently it works great.

Yesterday, the New York Post featured the Boxee/AppleTV set up in an article it titled "The Future of Television." It is an interesting read, both for the mechanics of the set-up but also for the discussion of where TV is going and how Boxee is changing the game.

Happy viewing! Click Here to Read More..

The Matrix is Closer Than You Think

Found this book review over the weekend. It looks like the Matrix (or the Terminator depending upon your age) is a lot closer to reality than I thought. The review itself is a crazy enough read that I am going to pick up the book. I'll post if it is as interesting as I hope.

A few key quotes:

The irony is that the military will want it [a robot] to be able learn, react, etc., in order for it to do its mission well. But they won’t want it to be too creative, just like with soldiers. But once you reach a space where it is really capable, how do you limit them? To be honest, I don’t think we can.

The reality is that the human location “in the loop” is already becoming, as retired Army colonel Thomas Adams notes, that of “a supervisor who serves in a fail-safe capacity in the event of a system malfunction.” Even then, he thinks the speed, confusion, and information overload of modern-day war will soon move the whole process outside of “human space.” He describes how the coming weapons “will be too fast, too small, too numerous, and will create an environment too complex for humans to direct.” As Adams concludes, the various new technologies “are rapidly taking us to a place where we may not want to go, but probably are unable to avoid.”

So, despite what one article called “all the lip service paid to keeping a human in the loop,” the cold, hard, metallic reality is that autonomous armed robots are coming to war. They simply make too much sense to the people that matter. A Special Operations Forces officer put it this way:

“That’s exactly the kind of thing that scares the shit out of me. . . . But we are on the pathway already. It’s inevitable.”

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Venture Capital for a 5th Grader

Sometimes you just have to keep it simple. Click Here to Read More..

Sunday, February 8, 2009

What do venture capital analysts do?

What do venture capital analysts do? And why do venture capitalists need them?

The link below is to a blog post from Scott Scheper that answers these questions. First, it sheds some light on the "glamorous" job that the analysts do within a VC firm.

Second, and perhaps most importantly, it illuminates the crucial difference between an angel investor and a venture capital fund. Angel investors typically do not have the infrastructure or desire to perform a proper valuation and financial analysis of the entrepreneur's company. They typically are investing by their gut or with their friend/family/neighbor. If you can sell them on your idea and on you, then you are most of the way there. Venture capitalists, on the other hand, report to a higher power -- their LPs. They usually will have a fiduciary duty to act with care in their management of the funds assets. More importantly, they need to keep their LPs happy so that the LPs will re-up in the next round of fundraising. When a particular deal turns out to have been a bad one, the VC will want to be able to demonstrate what they were thinking at the time they made the investment. This is why they need to do the fulsome valuation analysis.

A third "sub" point -- the article also alludes to the tension between what types of investments an early stage VC fund is interested in and what types of investments an angel may consider. If it can't be shown through a full valuation that the idea has the potential to hit the VC's desired returns, then the investment will not be made. A very exciting idea may not receive interest from a VC because it is either too speculative or because it is not obvious that the desired returns will be there. These sorts of ideas will be dependent on angel funding until they have proven their concept -- or perhaps exclusively until they have the balance sheet for debt or can find an exit through M&A or IPO. For more on the types of returns that different investors seek at different phases of a company's lifestyle, here is a recent blog post of mine.

What do venture capital analysts do?

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Saturday, February 7, 2009

Apparently the Network is Real

Wow -- very cool.

Thanks to BGR for posting. Click Here to Read More..

Friday, February 6, 2009

"We've made a fetish of markets."

A second clip from bigthink featuring Michael Lewis of Liar's Poker fame (among other things). The first one is here.

In this clip he focuses on the financial markets and the mistakes that led us to this downturn. It is a longer piece, but has some real gems throughout.

A few notable quotes:

1) The SEC is very good at hounding people who have done trivial things.
2) We actually were deluded into thinking that nothing could really go wrong.
3) The money that was being invested had no capacity to understand what it was being invested in.
4) There is a natural limit to the amount of complexity the markets can assimilate.

If you like Michael Lewis, don't miss his excellent article on the melt-down found on Click Here to Read More..

Smart Money for 2009 -- Growth Stage Venture Capital

Rather than investing in new concepts and start-ups, growth stage venture capitalists focus on companies that are already profitable and relatively mature. These companies may be looking to enter a new market, to finance a bolt on acquisition, or to expand operations.

A recent Forbes article noted that in the current economic environment, venture money is gravitating away from the high risk/high return early stage investments to the more moderate risk/moderate return growth stage investments. This move towards growth stage investing may also be a result of the relatively large venture funds that have been raised in recent years. Growth stage investing requires larger investments (from $5 million to $100 million or more) and is more suited to the multi-billion dollar funds found in recent vintages. In an early blog post, I noted that these larger funds would also gravitate towards the capital intensive VC sectors that are popular now -- such as cleantech and biotech.

You may wonder why these companies that are generating revenue and have operating profits would turn to an equity investor rather than simply borrow the money they need, since debt is usually cheaper than equity. Typically, it is because debt is unavailable for one reason or another. Perhaps the company already has too much (or just enough) debt on its balance sheet or it has unstable or lumpy earnings that are difficult to borrow against. Or perhaps the new opportunity that the company sees is just too expensive for the company to finance entirely with debt.

Growth capital really exists at a cross-roads in the private equity world. On the one hand, it is frequently financed by venture capital funds that will approach it as a minority investment and will negotiate accordingly. On the other hand, larger private equity and buy-out funds will consider taking majority stakes or even minority stakes that have contingencies that can lead to buying the company as a whole -- e.g. buy/sell arrangements, put rights, drag along agreements and rights of first offer/first refusal.

For a broader treatment of the various financing stages a start-up company may pass through, check out my Flora and Fauna of Venture Capital blog post. Click Here to Read More..

Thursday, February 5, 2009

Why Don't Venture Capitalists Like Investing in LLC's?

When an entrepreneur hopes to raise venture financing, a very common mistake he can make is to form the wrong type of entity or to form it in the wrong state. Choosing what type of entity you should form -- that is, choosing between a basic "C" corporation, a limited liability company, a limited partnership, an "S" corporation or a general partnership -- can be a very complex choice and I am not going to go into all of the legal and tax ramifications here. However, venture capitalists have very distinct and particular opinions on this decision. By making the wrong choice you will hamper your ability to raise venture capital and/or create costs and complexity down the road when your prospective VC request you "do things over." More after the break.

Potential venture capital investors have clear preferences and expectations as to how their transactions will be structured. Generally, in order to get a venture capital investment, you will need to be organized as a "C" corporation and it is preferable that you be incorporated in Delaware.

VCs will almost never invest in limited liability corporations and will rarely invest in corporations formed in states other than Delaware. VCs will virtually never invest in a partnership and are forbidden from investing in an "S" corporation. In many ways, by forming the wrong type of entity in the wrong state, you will demonstrate your inexperience with and ignorance of the venture capital process. This is the last thing you want to do when you are trying to show off your entrepreneurial savvy to a potential investor.

This is not to say that there are not advantages to be had with different entity types. However, the venture capital process is form driven and the corporate form is tried and tested. Folks just know it works. Every VC has its own set of forms that it basically uses for all investments on which it is lead. The VCs and their attorneys know the forms inside and out and are comfortable quickly making adjustments and changing deal points that will flow across multiple forms and multiple sections within a form. Further, the rights, preferences and privileges of preferred stock are fairly standard and will not vary too much in a particular region and time period. Also, corporations are easily able to issue tax favorable stock options to incentivize their employees. Finally, VCs are comfortable with how to realize liquidity in a corporation -- through IPOs, liquidation events and dividends -- and they understand the various tax treatments.

To make a VC investment in an LLC would require an entirely new set of forms developed from scratch. The classic rights, preferences and privileges of a VC preferred stock investment do not translate easily or comfortably into the LLC format (although, admittedly it can be done). Developing these scratch documents is a costly endeavor (and obtaining venture capital is not cheap anyway) -- it is unlikely at best that a VC will want to bear these additional costs. In addition, an LLC is not able to issue stock options to its employees with the same tax advantages as a corporation. Also, the manners of obtaining liquidity in an LLC (through distributions or liquidation) do not translate easily into the VC world and have potentially different tax treatment. For example, the flow-through tax treatment of an LLC could potentially cause problems for the limited partners of the VC. Finally, and perhaps most importantly, it is not possible to do an IPO with an LLC. Any LLC that wanted to go public would be required to first convert to a corporation anyway with potentially very adverse tax consequences.

This is not to say that an LLC is not an excellent choice for joint ventures or small businesses which will never need to raise money from a VC. LLCs are very flexible entities that can provide favorable tax treatment for individual investors. It is just exceptionally rare to find a VC that is willing to invest in an LLC.

The choice of state question is not as clear cut. However, most venture capitalists have a clear preference to invest in a Delaware corporation. This is because Delaware is still the most common state of incorporation and, consequently, the statute is well thought out and practical and the courts in Delaware are very experienced with corporate law. Delaware law is also very flexible in providing indemnification for officers and directors and for protecting officers and directors from claims of a breach of their fiduciary duties. Nevada law is not a viable alternative, despite the claims of internet incorporation firms to the contrary. It may have similar laws, but it does not have the same experienced judges. On the other hand, it is common for a local venture capitalist to be willing to invest in a corporation formed under the laws of its home state (Virginia for a Virginia VC, California for a California VC), but why limit yourself to local VCs by choosing the local jurisdiction?

In sum, if you are considering starting a business that plans to seek venture capital at some point, you should strongly consider starting out as a Delaware corporation. It happens too often that an entity is ready to start or receive fundraising but first has to re-do its charter documents at great expense and with adverse tax consequences. Venture capitalists simply do not like investing in LLCs.
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Dividends and Preferences by Hank Heyming is licensed under a Creative Commons Attribution 3.0 United States License.