It is when a startup grows its business to the Company stage that it can get exceptional value (<$100M). In general this takes experience and skills that aren’t usually found either in a startup or on their board.

Most angel-backed startups have trouble making it beyond the feature or product stage. In the past, many startups counted on VC funding to grow to the product line and company stage. This is now exceedingly rare, given both the number of angel-backed startups and the limited activity of VCs (see some of my previous posts).

So what does that mean? One outcome is that we move our angel-backed startups to profitability and they grow organically. This can lead to an acquisition, but more often than not, exits are rarer than we would like. (I will be doing a post on this soon.)

I predict that we will begin to see a wave of mergers between successful angel-backed companies. This makes perfect sense.

When two companies are in alignment and have products/features that can satisfy a broader set of customer needs, builds revenue and a customer base that exceeds critical mass, and gives the combination the chance to get to the company stage – creating a lot more value than the two companies separately.

• A company has taken quite a bit of investment, usually from institutions and angels.
• The deal that was struck has a liquidation preference (if you don’t know what this means, you should educate yourself). Good terms for companies meeting their goals are 1x participating preferred (sometimes capped); bad terms are 2x to 3x and usually granted when a company is in trouble and needs to raise money.
• Acquisition seems like the best alternative, but the offers are for less than the liquidation preference (or not much more than the preference).

In this case, the common stock and options are essentially worthless. The founders, employees, and others who bet on the upside find themselves in the position of having worked for little-to-no upside (or in the case of board members or consultants who took options – nothing!).

What is the board to do?

Here is my perspective:

• Recognize that management did not deliver the value that was promised when the money was taken. It is not fair to give management a great return, while investors lose money.
• On the other hand, it was management’s sweat that got the company to exit. This needs to be rewarded.
• The board should try, as a first priority, to ensure that management gets a good deal from the acquiring company. This is good for the acquirer and allows the proceeds to go to investors.
• If a carve out is necessary, I believe that it should be graduated (like a graduated income tax). In that way, as the investors do better, management increasingly does better. This aligns incentives. For example, if the liquidation preference is $10M and the acquisition will be in the range of $5-15M, the carve out might look like this:
  • 5% of proceeds for the first $5M (which is $250k at $5M)
  • Between 5-10M, $250k plus 7.5% of the amount over $5M, which is $375k at 10M
  • $875k plus 10% (plus the value of their stock, which is now in the money) for any amount over $10M
• This seems to give both aligned incentives and balance the reward for management with the need to get investors their money back.

Of course, all of this looks much better when the company sells for a lot more than was invested!

In one case, the board, without any form of communication about the company’s status or consultation to the vast majority of shareholders, in short order (1) forced a “pay-to-play round” led by two institutional investors; (b) granted the CEO and other senior managers a HUGE carve out (despite several years of missed targets and poor performance); and (c) negotiated a quick sale of the company where the winners were the management (who got the carve out and a bonus from the acquiring company) and the institutions that forced the pay to play. This was done by a board that was incredibly conflicted, but counted on the fact that the angel investors in the deal (there were about 30 of us) wouldn’t take any action. Payout to the angel shareowners - $0. That’s right – nothing. This is egregious, but not uncommon.

Angels need to be willing to take better actions to protect their investments.

1. We must be willing to band together. I am working with several attorneys and the Alliance of Angels to create an LLC that can be used to aggregate our investments in a company. In this way, we will in aggregate be a “major shareholder” in the startup and get rights and privileges commensurate with a VC. This will add a small expense to our investing and require some overhead, but it should be worthwhile. And the company should love this, since this will be one shareholder instead of many.
2. We need to insist on a board seat and assign one of our members with sufficient experience to take that seat.
3. We must insist that our CEOs communicate, communicate, communicate. I get frustrated with a CEO that has bad news and decides not to share it until there is good news. Often the only communication is one from the law firm representing the startup and usually that is really bad news. Funny how the CEO was quite communicative while raising money from us. Boards need to step up and make sure that their CEOs treat their investors with the respect that they have earned by investing in the company.
4. Boards must represent shareholders in holding management accountable. I’m not saying be obnoxious. But, if you hired a contractor to fix your house and they didn’t do the work they contracted for, you wouldn’t pay them the full amount. Why do boards feel it is OK for a team to miss on their execution and then reward them? Boards need to step up.
5. Carve outs need to be measured. I understand that an acquisition can only occur with a willing management team (and a willing board). If there is a large liquidation preference overhang, (as there often is) management’s stock might all be under water. There is a need to take action to make sure that rewards are balanced. Boards need to be proactive in this. I will be posting a separate blog on my assessment of best practices on this.

So.. investors need to insist that board really do represent them and not allow them to take the easy way out, create conflicts of interest, or have investors take it on the chin. Boards – step up!

Shortly after joining the board, I began to try to study and make sense of our metrics – especially euthanasia numbers. I well understood that not every animal was “adoptable,” some were too sick to be saved or had behavioral problems that made them unsafe to be in a house with either other pets or small children. But the numbers just didn’t make sense to me. So, along with the support of other board members, I began to ask for more details on the metrics, drilling to the next level of numbers. What emerged was a picture of management controls and lack of consistent strategy that meshed with the desires of the board. As a result, the board changed management first on an interim and then permanent basis. And, we established a goal that “no adoptable animal in our care would ever run out of time or space.”

Over the course of a few months, we focused on a metric that matched that goal (it’s called the Asilomar Live Save Rate) and have been successful in maintaining that metric at a level that qualifies us as a so-called “no kill” shelter for several years since. And then we were able to go to important, but secondary, metrics (e.g length of stay until adoption) that improved our operations and the care we gave our animal guests. I am proud of these accomplishments, but it has caused me to reflect on the importance of goals, strategy, and leadership in a more general sense.

In both the non-profit and start-up worlds (some claim many of my startups are non-profits! J), understanding your goals is a critical element in success. Goals must be meaningful to the organization and actionable. And have corresponding metrics that match those goals.

This seems simple, but in several of my companies, this has proved exceeding difficult. Many metrics follow results by too wide a gap to be actionable. In many cases, revenue is such a metric. But in almost every case, there are a handful of “value drivers,” those metrics that truly derive the value and health of the business. For example, in a telecoms consumer services business (like one a ran earlier in my career), the key value drivers were, (1) cost of customer acquisition; (2) average revenue per customer; and (3) churn. For each business type, these will be different.

The power of setting a good goal, understanding your value drivers/metrics, and having a strategy to maximize those value drivers and fulfill the goal is the path to success.

I love film (as well as theatre). I’ve loved movies for as long as I can remember and (from my previous posts) you know that I found the new 3D/IMAX experience entertainment-altering. I’ve also blogged about setting up my home theatre to watch movies and loving Netflix on the iPad. I enjoy the output of the film industry, but really have no knowledge about film as a business, nor have I ever given it much thought.

I found myself at a film studio, sitting among a panel of film experts, including experienced producers, speaking to an audience of established and aspiring film makers, producers, and directors. As I listened to them speak, I realized why I was there. There really were a ton of similarities!

Listening to a producer discuss how the director and stars had a strong desire to create the vision exactly the way they wanted it, without regard to the budget, sounded like a conversation I had just had with the CTO/founder of a tech startup who had delayed shipping on schedule to get it exactly right. A discussion about the need to consider marketing budgets in film production sounds so eerily similar to that of a web company that had only budgeted sufficient money to launch their product, but not enough for distribution. And there was a long discussion about using social networks to enhance views that could have been a web startup as well as a movie.

The similarities do abound. Is a short film marketable? (Is a single feature company marketable?) Can a director be a producer as well? (Can a tech founder be a CEO?) Etc.

But for me, the biggest learning experience is how the movie industry has paralleled the tech industry. It used to cost many $M to produce a film, just like it used to cost $20+M to build a software company. You can now produce a film for several $100k’s. The technology has made it easier to do the filming, do the editing, etc. Even distribution is changing markedly. For example, you can distribute a film entirely on line, using services like YouTube and Netflix.

However, I also realize that, while I have some expertise in startup deal structure and terms, this might not apply to film ventures. I haven’t yet taken the time to review the kind of deal structure, partnership arrangements, rights, etc of a film deal. Nor have I looked at the business/revenue models that apply to film. I sense that most film investors do so more on gut, instinct, and passion than the smart tech investor.

The main difference is that most tech (or medical) startups create a product that doesn’t have to be a “hit” to succeed. If you get it wrong, or your timing is wrong, you still have the opportunity to fix the situation. This makes investing in a single film very different than investing in other startups. Most of our tech startups are more like investing in a studio than a film. This might dissuade a tech angel from film.

Comments from experienced film investors very welcome.

It took me quite a while to find the number I could call, but eventually did. With that number in hand, I called Microsoft customer service. The first person I spoke with just took my info, gave me a case number, said that I qualified for free support, and transferred me to tech support. My call immediately dropped and I had to call back. With my case number in hand, I got right through to Jeff, who spent the next hour on the phone with me to fix the problem. First, he took the error code I had received and did some research. Within a couple of minutes, he knew exactly what caused the problem – it was my optical drive which (while working for files) would occasionally fail and not find a file. He then suggested that I copy the installation files, which my drive wouldn’t do. So, he recommended going to another computer on my network, copying the disk there and then using the network to install it. That worked! And then it installed perfectly.

Through all of this, Jeff from Microsoft in the Philippines, could not have been more knowledgeable, friendly, or helpful. Not happy that the install didn’t work on the first try, but very happy to have such a good level of support.

My old Netgear router, which had been the paradigm of reliability, died suddenly last week. It was over two years old, so I didn’t complain too much. Instead, I made an emergency run to Fry’s and purchased the top-of-the-line WNDR3700 Range-Max dual band wireless N gigabit router. The two main features I really liked were: (1) very high speed processor that should give better performance, and (2) ability to configure 2 SSID’s, so that a visitor could gain access to the internet without getting access to either my security phrase or my local data. Very cool I thought.

Setup took me a typical time – about an hour. And after the usual of downloading the latest firmware, having to reboot all of the other switches and my modem, I was on the internet, transferring files, etc. The wifi worked with my iPad and iPhone. And for those regular readers, it also worked with my home theatre control system. All was good in the world again.

Given that it was past midnight when I finished, I waited to add the cool new features till the next day. It was then that my router stopped working. I enabled the guest SSIDs, and suddenly the wifi was dead. I went into the configuration menu, and noticed the radios were turned off, so turned them back on – only they didn’t go back on. So, I looked at the router, and the lights for the wifi were off. I manually turned them on. But they turned off on their own again as soon as I downloaded the config. Thinking I had inadvertently misconfigured the router, I reset it to factory configuration and started again. Then the problem repeated itself as soon as I turned on the guest network. I played with the various settings, but it happened every time. So.. I concluded I had a defective unit.

The next morning, I hopped in the car and drove the 15 miles to Fry’s, who were gracious about the exchange. Got the new unit home and it was exactly the same. By this point, I had invested well over 8 hours on this, not to mention the previous 4 I spent figuring out that my old modem had failed.

So, I began investigating on the web, only to learn that this has been a known problem with this unit since March. (See: http://forum1.netgear.com/showthread.php?t=49720&highlight=guest+ssid). The original bacth of routers sold prior to January, apparently do not have this problem. But the ones sold in 2010, all suffer from this issue. There has been a beta firmware upgrade available for two months that fixes the problem, but seems to have other issues. Netgear will release it, but only under NDA! So the message is, you have to suffer, call our customer service, be put on hold, sign and NDA, and then we will give you a less buggy upgrade, for a product that didn’t work to begin with. In other words, Netgear has known that they are selling a defective unit for over three months, continue to sell this unit, have not notified their retailers, and let customers know that this was a problem.

This is intolerable and unacceptable behavior, the kind that should be punished by fines, and big ones at that. My time is valuable to me, but apparently not to companies like Netgear that feel it is acceptable to have their customers to their testing, spend countless hours making a defective product work, and then have to beg for a solution that exists. They should just recall this defective product and either replace it with one that works, or refund 100% of their customers money, and also give a credit for future products.

This is not a problem that has appeared over night; it has been decades in the making and can’t be cured with a single act.  The industry has matured, and Microsoft is still run like the company it was 20 years ago.  It lacks the visionary who can anticipate what its customers will desire and the ability to delight and surprise (in a positive way) those customers with a clean and crisp innovation.

Microsoft has become the IBM of the last generation – it is a de facto enterprise solution and “no one will get fired for selecting Microsoft.”  Microsoft had the ability to lead the way in the Internet, but it instead focused on the competition inside and didn’t dream the big dream.  Worse – it became boring!

Look at Windows Vista and Office 2007.  Neither were improvements on previous versions, nor were they more stable or easier to use.  And, of course, Microsoft had the clear shot at the Smartphone operating system.  Instead, it tried to bring us Windows on our phones.

Customers wanted new thinking, sleek products, and ones that were much easier to use.  The iPhone was really a breakthrough – a browser-based phone that was truly useful and enabled 1000’s of cheap, easy, and imaginative apps.  Apple unleashed the imagination and creativity of an entire generation.  And then they extended it to the iPad.  They took leadership of the entire industry.  They earned the mantle.

The fact that a large company loses its ability to innovate is not a surprise.  I call this the  ”$0B Business Problem.”    As an illustration, I was the first GM of the Microsoft Search team.  We had a great plan to lead the search business that would grow to a new $250M business in 3 years. (Any VC would have funded this business; it returned over 50x ROI.)  But we competed for resources with Excel, which needed the same 25 headcount, and had an net present value of $4B.  In that context, my $250M rounded to $0B, and we didn’t get the people.

Microsoft needs to find a way to unleash it’s innovation.  It needs to behave more like  a startup.  When I was there, I suggested Microsoft form a group called “The Idea Factory,” where innovative and entrepreneurial employees could “spin in” (rather than spin out) a new idea, and create a startup around that idea.  The notion was that an internal VC group would vet and fund a portfolio of ideas, in exchange for ownership in the new company(newco)  and a right to acquire the entire company at a later date at a market price.  The employees who transferred to newco would exchange their options/restricted shares for newco stock.   And the newco would hire a great startup CEO to build the company.  These newcos shouldn’t be constrained to “work within the existing system,” or you will get another Windows Mobile instead of an iPhone.

Changing leadership at Microsoft, but keeping the system, won’t change the company’s trajectory.  Acquiring a large and already successful company won’t solve the problem.  Nor will decreeing that it is going to “kill Google,” or “kill iPhone.”  Microsoft still has the most formidable research and intellectual ability in the industry.  Microsoft needs a better vision, one that is tied to delighting customers.  Technology that is easier to use and just works.  And technology that surprises it customers.  If Microsoft can’t make this transition, it risks becoming irrelevant in the industry. That would be sad.

http://banking.senate.gov/public/index.cfm?FuseAction=Newsroom.PressReleases&ContentRecord_id=a8a93650-936c-1e68-27b0-a38401ac9619

Thanks to all of the angel investor groups who contacted their Senators, and thanks to those Senators who recognized the importance of our mission and got the entire Senate to support our cause.

Thanks, Richard [Sudek, the chair of the TCA and outgoing ACA board member].

It was just one short year ago in Atlanta that Luis and I decided to walk back from dinner and discuss our shared passions for Angel investing and innovative companies.

It is my distinct pleasure to introduce Christina Lomasney and Modumetal – both of whom embody my discussion with Luis and a great example of Peter’s [Diamandis, Chairman of the X Prize Foundation, who had just spoken] exponential company.

In more than 25 years of investing in and starting companies, it is rare to see an idea that can create and industry and change the world. Modumetal is such a company.

Christina has inspired the Alliance of Angels and other local angels with her vision to invest more than $4.9M. And inspired her employees to achieve great things with limited resources. And inspired large customers to bet on this early stage startup. Modumetal is a great example of why we angels do what we do – investing in innovative startups and helping them change the world.

Join me in recognizing the 2010 Luis Villalobos Award winner – Modumetal and Christina Lomasney.

Here is the ACA Press Release:

For Immediate Release

Contact:

Marianne Hudson
ACA/ACEF
913-894-4700 x1 (or 816-668-2248)

mhudson@angelcapitalassociation.org

Contact:
Erich Mische
Modumetal
877-632-4242
erich.mische@modumetal.com

Modumetal Named 2010 Luis Villalobos Award Recipient

National Award Recognizes Most Innovative Idea Financed by ACA Angel Group

San Francisco, CA, May 6, 2010 – The Angel Capital Association (ACA) named Modumetal of Seattle, WA, as inaugural winner of the Luis Villalobos Award.

The national award, which was established in 2010 to honor the late Mr. Villalobos, founder of Tech Coast Angels and a true “leading light” in the angel field, recognizes the most ingenious and innovative idea recently financed by one of the member angel groups of the Angel Capital Association.

Christina Lomasney, Modumetal co-founder, president, and CEO was presented the award at the 2010 ACA Summit in San Francisco, CA. The Summit was attended by 400 angel group leaders and investors from the United States, Canada, and 23 other countries.

“Luis was an innovator and a ferocious learner and tireless entrepreneur supporter,” said Richard Sudek, chairman of Tech Coast Angels and chair of the Luis Villalobos Award committee. “He started one of the early angel groups, and was intrigued and excited about innovative technology, science, and new ways of doing things. It made so much sense for ACA to honor Luis with this award which recognizes entrepreneurs who make very unique contributions that are disruptive or game changing.”

Modumetal is creating a new class of ultra-high performance nano-laminated materials.

“The leadership and support that Mr. Villalobos represented in helping entrepreneurs to realize their visions for the world echoes clearly today for Modumetal in his stories, his example, and in his own perseverance in realizing the Tech Coast Angels.” Lomasney said. “The Modumetal team is grateful for Luis’ inspiration and is honored to be the first to receive the Luis Villalobos Award for innovation.”

The Modumetal by Design™ process uses electricity instead of heat to grow metal from the ground up, in nano-scale layers. Modumetal, a revolutionary nano-laminated alloy system, is stronger and lighter than steel, can run longer and hotter than nickel-alloys, is more corrosion resistant, and costs less than stainless.

Alliance of Angels (AoA) of Seattle, WA co-led a multimillion-dollar Series A investment round in Modumetal. The syndicated round included significant investment from AoA members as well as from co-lead investor Second Avenue Partners and the Washington Research Foundation of Seattle.

“Between the people, the product, and their approach, I think Modumetal is one of the most creative and innovative companies in my twenty-five years of investing,” said Dan Rosen, Alliance of Angel chair.

Modumetal’s nano-laminate alloys have the potential to create an entire multi-billion industry that will transform transportation, aerospace, energy, and defense industries.

“This is exactly the sort of deal that Luis would have loved,” Rosen said. “Modumetal has inspired its employees to achieve great things, its investors to believe they can change the world, and its customers to work with this small startup to implement this striking innovation and change the way things are done.”

–

The Angel Capital Association
(ACA) is a trade association that supports angel investment groups in North America. ACA was founded by angel investment groups located in the United States and Canada to help maximize the success of group based angel investors. (www.angelcapitalassociation.org)

Modumetal of Seattle, WA, is realizing the commercial potential of a unique class of nano-laminated materials. The Company is creating materials that will change design and manufacturing of metals by redefining structural, corrosion, and high temperature performance. Modumetal is made by a “green” electrochemical manufacturing approach, which reduces the carbon footprint of conventional metals manufacturing at the same time that it revolutionizes materials performance. (www.modumetal.com).