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.
Click Here to Read More..

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.
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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 Smarta.com, 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.
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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..
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Dividends and Preferences by Hank Heyming is licensed under a Creative Commons Attribution 3.0 United States License.