Category Archives: VC

Aprimo – what a wonderful year-end surprise

I was the founding managing partner for Frazier Technology Ventures (http://www.fraziertechnology.com/), which unfortunately was founded in May 2000, possibly the worst time for starting a new venture fund. Up until last week, the fund’s performance was in the middle of the pack (and therefore did not come close to returning capital). This was a financial, professional, and personal disappointment for me.

After more than 10 years, the fund had only one surviving company that was still private and alive, Aprimo (http://www.aprimo.com/), an integrated marketing software company. The founder and CEO, Bill Godfrey, started with a vision that marketing professionals needed a strong and consistent platform that supported their needs and aspired to fill that need. He was supported by good investors, who shared that vision and stood by the company in the lean times as well as the flush ones. The FTV board member, my partner, Gary Gigot, had consistently forecasted that Aprimo was creating a new category, would dominate that category, and therefore would be a very valuable company.

And then on December 22nd, Teradata announced that it would acquire Aprimo for “approximately $525 million” (http://www.aprimo.com/TD/). The transaction is expected to close sometime in 1Q2011. Well done Bill and the Aprimo team! This is a spectacular outcome for Aprimo, Bill, and the investors, as well as for Teradata.

And this acquisition wraps up Frazier Technology Ventures I on a high note, placing FTV I in the top quartile of its peers in that vintage. For all of my friends that invested in my fund, I am thrilled that your faith in me turned out OK.

Angel Investing is Vibrant and Getting More So

Not much surprises me these days, particularly during this mud-slinging political campaign season.

However, Marcelo Calbucci’s Tech Flash post (http://www.techflash.com/seattle/2010/10/have_we_killed_the_angel_investor.html) did. How my posts could be so misunderstood by someone I respect baffles me, especially when that misunderstanding is posted to a widely read blog.

My previous post on Angels forming LLCs for their investments IS entrepreneur friendly, and based on national best practices. Any entrepreneur who has a successful venture with 50 angel investors knows the pain (including excessive legal fees) for getting signatures on every shareholder issue. If a large number of these angel investors are in an LLC, you only need one signature – much more efficient and much less costly. This is the practice in many places, including some of the largest angel groups in the Bay Area and East Coast. It is not widely done in Seattle. And it is not a way to get better terms in seed and A round investments; there really is no relationship between the two.

It is a way for Angels to preserve their rights in the face of a VC round that follows. VC’s typically don’t like to have to get 50 signatures, so they reserve certain rights to “major investors” in their term sheets. This typically either washes away or severely limits the investor rights of Angels, once VCs have entered the deal. It is definitely in the interest of the entrepreneurs, Angels, and the company to make sure that a broader base of investors has a say in the future of the company; the trust from shareholders (the owners of the company) that they will be treated in an open and democratic way is the basis of our entire equity system.

Angels who work together to learn best practices make for a much stronger ecosystem. That is why I spend so much of my personal time trying to learn from other angel groups, both locally and nationally, about what works and doesn’t work. My colleague Angels do likewise. We run a bunch of educational events locally to share our knowledge and insights and encourage other Angels to strike deals that are balanced between return and being entrepreneur friendly. It is why I spent so much time crafting a “Series A Angel Term Sheet,” (http://drosenassoc.com/Draft%20Term%20Sheet%20for%20Alliance%20of%20Angels.pdf) that is now being widely used, not just in Seattle, but around the world. It simplifies the process of bringing in early money for startups, while lowering the costs. All of these activities lower the barrier for entrepreneurs raising money, not as you assert, making it more difficult.

Angel groups are a fabulous way for an entrepreneur to raise money. It is much more efficient to present once to 60 active angels than to set up 60 individual meetings. I don’t know one entrepreneur who would argue with that proposition. And, through the Angel Capital Association (a Kauffman Foundation spinout), we are now sharing best practices, participating in educational events, making sure that public policy encourages early-stage investment (e.g. http://blog.drosenassoc.com/?p=41), making sure that as many Angels as possible enter the ecosystem, and encouraging each other in bleak economic times.

As part of this socialization, it is evident that Seattle IS progressive. We have funded as many or more early stage deals at a slightly higher price than our peers in the Bay Area and Boston. Your assertion that entrepreneurs in the Bay Area are getting their deals funded without a financial projection or a solid plan is an urban myth that is not supported by fact; it encourages behavior that neither helps entrepreneurs or investors. We do help the “the next great idea from two guys who are just finishing their computer science degree at The University of Washington” in part by helping them understand what it means to create a great business. In my 25 years of experience, I have not seen a success where throwing money at people without a great business concept created a great business. It is the marriage of great technology, great people, and a great plan that makes the breakout companies. Yes, this takes some discipline and hard work. Saying that the best model is angels willing to throw money at entrepreneurs who are not committed to a disciplined approach is not only wrong, it does a great disservice to the entrepreneurs willing to quit a high-paying job to risk everything to build a great company.

And during the last year, I’ve spoken at events throughout North America without reimbursement. Like you, Marcello, for me this is a passion, not a business. But most Angels need a return on their investment, if they are going to continue to invest. We need more maturity in the process, not less.

We all want to see more intelligent, high-net-worth individuals in Seattle become Angel investors. They way to do this is NOT by telling them that they should “invest and pray”. It is by showing them how to be successful angel investors, how to lead deals without as much pain as in the current process, and by making it easy to pull the trigger on their first few investments. One way that other communities (e.g. Bellingham) have used is the deal-specific LLC that started this conversation.

Success will come by finding more ways for entrepreneurs and Angels to communicate and understand common goals and then achieve extraordinary results. And success will build more success.

Startup Company Boards

Startup companies need good boards. But they often don’t have them.

There are many reasons. First, there really aren’t that many experienced people willing to serve on a startup company boards. And those that are experienced, skilled, and bring a lot of value, generally want to be compensated, which startups can’t really afford.

VCs will serve on boards, but generally when their fund owns 15% or more of the company, so their compensation comes from the fund and the upside from a huge amount of stock.

In contrast, individual angel investors usually only own a very small (<2%) of a company and there is no ready mechanism for their co-investors to compensation.

So.. what makes a good board member? Many startup CEOs believe that the most important factor in choosing a board member is industry experience. I disagree. Industry experience is valuable on an advisory board, but needs to be resident in the company. Some degree of industry experience is, of course, beneficial. But, the following experience is more important on a board:

  • Experience on other boards for high-growth companies;
  • Having been through financings of various sorts;
  • Experience in acquisitions and IPOs to understand the inflection points and needed metrics;
  • A good rolodex relevant to the company;
  • Good chemistry with the CEO and other board members; and
  • A willingness to be direct and outspoken about the company, even if that position is unpopular with management and the board.

To get good board members, a startup company must be willing to compensate board members (as they do management). I’ve spoken with a number of angels and angel groups around the US and found that board stock compensation seems to vary widely. On the West Coast (primarily the Bay Area) and Boston, compensation seems to follow the VC model – no additional compensation is required. However, in much of the rest of the country, options are generally routinely given.

I’d recommend the following package for a pre-A round company: 1% of fully diluted stock, vesting over no more than 2 years. Shorter vesting is generally a very good idea for board members in order to make sure that board members don’t try to act to save their board position rather than do what is right for the company. Of course, if the company is already financed and has suffered the dilution to do so, then the percentage would be less.

I believe that the Angel Capital Association, the Kauffman Foundation, and/or a university business school should conduct a survey on this.

Professional Angels: the new early stage VCs

As I’ve blogged before, the market conditions are driving early-stage investment capital back to basics.  VCs have always fostered great entrepreneurs with great ideas.  But the model has changed profoundly and permanently (see my earlier blog: “Why the VC Investment Model is Broken”). 

So how do great entrepreneurs build their business in 2009?  Professional Angels.

Most professional angels are members of angel groups.  (See http://www.angelcapitalassociation.org/ for the largest trade association.)  In these groups, members generally act as individuals for their own investment, but team on the key aspects of deal sourcing, deal screening, due diligence, investment pooling to ensure that there is sufficient capital overall for the company, and then monitoring the deal afterwards (including board representation).  In this regard they act like an early-stage VC fund, but the decision making is on an individual basis.  In the Seattle Alliance of Angels (www.allianceofangels.com) these groups have grown from an average size of about 2-3 investors to 6-12 investors in the last 4 years.  Such organization makes life easier for the entrepreneur, since they only need to negotiate with one person (the “lead investor”) and they get more money.  From the angel investor point of view, there is more leverage on the deal, more shared due diligence, and the knowledge and wisdom that comes from the entire group.

Professional angels in groups also behave differently than the individuals.  Most, if not all, now reserve for follow-on rounds (even though the entrepreneur’s business plan might call for this “being the only round of financing required”), just as a VC would do.  For example, the Alliance of Angels did 44 transactions in 2007, with 15 being new companies; 29 were therefore follow-on rounds.  In 2008, this pattern continued with the AoA doing 36 investments, where 19 were new, so 17 were follow-on.  This behavior allows an angel group to carry a company through from inception to cash flow positive in many cases.  No VC or institutional funding is required for this sort of deal.  This is a new phenomenon that will help shape the market going forward.

The implications of this are the following:

1)      Angel groups and funds can and do provide the capital needed for a capital-efficient company to make it to cash flow positive.

2)      Entrepreneurs and investors are positioned for more rapid exits, since the valuation needed for a successful exit is often much less.  If a startup takes in VC money, it will often require an exit over $150M for a successful exit (http://blog.drosenassoc.com/?p=7).  These exits are rare and the company often either fails or is sold for the liquidation preference, so the entrepreneur does not have a successful outcome.  On the other hand, if the total capital is low, even an exit of $20-40M can be hugely positive for both investors and entrepreneurs.

3)      Companies can now be built in a more capital efficient way.  With better tools, open source, Amazon Web Services, stimulus money, SBIR grants, etc. small amounts of capital can now go a long way.

Professional angels are filling the void created by VC funds getting larger and startups being more capital efficient.

Why the VC Model is Broken

Why the VC Investment Model is Broken

 

Before anyone worries about my title, Sequoia, Kleiner, and NEA will be fine.  Any of the very top Valley firms see hundreds of deals a month, only do a handful every year, and have all the capital they need to finance even the largest startup plans.  Since they are on sitting on a series of large funds, their management fees allow them not only to make sufficient money per partner, but also pay for any resources they need to both attract good deals, but also bring on board luminaries to help them understand where the market is going. 

In contrast, the small and medium size firms (and anyone on less than fund 4) have a very different situation, particularly if they are not in Silicon Valley or Boston.  Let me illustrate this with an example.  Let’s say Fund X has $200M under management, has 5 partners, and plans to have their money allow for four years of investment.  Then each partner invests about $40M during the life of the fund or about $10M each year.  Considering that each partner does on the average about 1 deal per year, which means that each deal must be about $10M invested and reserved into each company.  Very few of the small or mid-tier VCs work alone, so that means that 2 or 3 VCs per deal – all with the same model.  Therefore, the plan is that each startup take in at least $25-30M in invested capital.

So given this reality, what must this company’s exit look like to get a venture return of 5-20x? Let’s use an example – an early-stage startup called Putrats.   Assuming that the VCs own 50% of the company, with the Putrats option pool being about 30% and the founders and seed investors having only 20%, then the value of the company must be about $50M to break even.  (Of course, things like liquidity preferences change that.  And could make a $50M acquisition valueless for the employees and founders!  More on that in another blog.)

For Putrats to qualify for an A round with a $10M pre money valuation, it must be an advanced startup, with product, revenue, and customers.  (You could quibble and say that’s not really a startup, but then you would be making my point!)  It is for this reason, that most VCs are no longer doing the same kind of seed and early stage investing that VCs of the last generation did.

So how does this work for the VCs?  This model will work if the IPO market is robust, but it is not and I don’t believe it will come back any time soon.  Most companies get their liquidity from acquisition.  (I used to be in the corporate acquisition business at Microsoft.)  While a very few exceptional acquisitions will occur at $250M, most will be in the $20-50M range.  The VCs that control the board and the preferred equity won’t accept a $50M buyout.  Instead they will continue to pump more capital into the company to grow bigger, eliminating all but a few acquirers.  This further dilutes the founders and seed investors.

So why do VCs do this?  And why to Limited Partners continue to invest?  The answer is a great paper story.  Let me explain. 

Let’s assume that Putrats’ first financing was done at a $10M pre-money and raised $8M, with each of 2 VCs taking $4M, or a post money valuation of $18M.  In the second round, they were joined by another VC who puts in $10M and the 2 previous ones each put in their pro rata of $6M.  In this example the post money valuation would be almost $50M and the VCs would now own 60% of the company.  This is fairly typical example. 

So why does this appear good to investors?  The first VCs in the deal get a write up on their $4M, since the value of the company has increased from $18M to $50M.  On paper, their original $4M investment is now worth over $8M.  Since the second round is usually within 18 months of the first, this looks like a fabulous return!

But at a $50M post money valuation, Putrats would need to be worth well more than $100M in acquisition value to get the same return on the new money, so the investment syndicate (now in firm control of the company) will reject any acquisition offer that is less than that.  It is a vicious spiral for the entrepreneur, who finds that their share of the company shrinking and exit options fewer.

This will catch up with the VCs sooner or later.  Management fees are 2-3% per year.  So for FundX, that is 2.5% of $200M or $5M per year.  Assuming that the active investment period allowed by the LPs is 5 years, and then the management fee decreases by half, then the total fees for a 10 year fund is $37.5M.  That means that FundX only invests $200M – $37.5M = $162.5M.  In order to break even (make a positive return), FundX needs to make 23% just to dig itself out of the hole. 

So why isn’t this obvious? – the J curve.  Historically, every VC fund loses money in first few years and then makes it up later; this is called the J curve.  Because the average time from investment to liquidity is about 7 years for a startup (except during the bubble years of the late 90s when the time to liquidity was very short), the only real metric that can be used to value the portfolio is the post-money valuation of the latest round!  So, on paper the VC return looks good for many years past when the result is set in stone. 

So… unless market conditions go back to very highly valued companies, one can expect lots of fallout.  I expect that VC will fall out of favor.  There will be consolidation, and dislocation ahead.