Year: 2011

University Spin-Outs

I am a big fan of high-tech companies. People that know me (and my co-investors) know that I like companies that are “changing the world” or “creating new industries” through technology innovation. And they know that I believe that research universities spawn great technologies and deserve public support. Universities do a terrific and efficient job of educating students, organizing research projects, getting and managing grants, and investigating science in a way that can make meaningful contributions to society.

I do not believe, however, that universities can do a good job of creating companies from the technologies that they create. This is a fundamentally different skill set than most (if not all) universities have as a core competence. It has been well demonstrated (e.g. Josh Lerner’s book, The Boulevard of Broken Dreams) that most governmental organizations don’t do well in creating or nurturing entrepreneurial businesses.

I do, however, believe that it is a fundamentally good idea to help start companies from university technologies. While the universities play a key role in making this happen, I am disturbed by a trend that seems to be emerging of universities establishing internal angel funds to spin out companies. It is a good idea to give very limited amounts of money and a great deal of support to key university faculty or grad students to help them understand if their technology makes sense to commercialize. Many universities already have small funds that give grants toward this end – something like $25-50,000 to help bridge the gap between pure research and a product or to pair business school students with engineers. But setting up multi-million dollar funds to compete with existing angels and VCs is a really bad idea.

It is really hard to take a new technology, build a company around it, and bring products based on that technology to market. This is something that VCs and, increasingly, angel investors have done successfully for many years.

History is littered with examples. How many states in the US and countries worldwide have decided to create “clusters” for specific technologies so that they could participate in the explosive growth of a new industry? Very few have been successful. Incubators have come and gone, wasting a lot of public money.

I believe that, instead of spending precious resources on trying to take companies from the “research stage” to the “company stage” it is a much wiser course for research universities to work with established financing sources for early-stage companies, like active angel groups. And for governments to help sponsor that collaboration by setting a public policy that incents angels who are willing to put their own money on the line to help create a company.

Many states have now established tax incentives along these lines. The Angel Capital Association has a summary of these activities. (http://www.angelcapitalassociation.org/public-policy/state-policy-kit/ ) This makes much more sense to me than asking universities to replace or augment Angels or VCs.

Severance – Oh No!

Many entrepreneurs, when they take outside money into their company, want to protect themselves. This is a perfectly reasonable thing to do.

The investors putting the first money into the deal also want some protection, especially when the founders own a vast majority of the overall stock and probably have a majority of the board seats.

One of the items that entrepreneurs sometime request is a severance package. In Washington State – DO NOT DO THIS. I don’t know about other states, but in Washington, the law apparently makes individual board members liable for any salary owed employees and not paid. For historical reasons, severance was considered salary in Washington. That would mean that board members might become liable for the severance of a fellow board member and company executive.

Clearly, this is a bad idea and the law needs to be changed.

But in the meantime, do not agree to a deal where there is a severance agreement.

I have modified my model term sheet to reflect this (http://drosenassoc.com/Model%20Term%20Sheet%20for%20Alliance%20of%20Angels%20revised%20May%202011.pdf).

AoA Results – why are they so good?

In my previous post, I noted that the AoA had a great year in 2010. (http://blog.drosenassoc.com/?p=61 or the full release http://drosenassoc.com/AoA%20results%202-23-11.pdf)

Typically, most angel groups or VCs see about 25-40% of their deals die in the first 4 years. (This is called the J curve, since the portfolio value goes negative for the first 3-5 years and gets positive when you begin to get exits in year 5 – this valuation curve looks like a J.) The AoA has what appears to be unprecedented results – almost all of our investments in the last 5 years are still alive! Many people have asked my why we did so well in a crappy market. I’ve certainly spent a great deal of time thinking about this. I believe that there are four principal reasons that caused the great year.

  1. World-class, innovative deal screening process. The AoA sees great deal flow, largely because we have a reputation of being savvy investors, who bring lots of value, and do “write checks.” One of the true core competencies we have developed over the last 15 years is our ability to take all the deals that are submitted and invest in the very best. This takes a lot of work, starting with our selection of our staff (both full-time managing director and 2 part time program managers) who have the right skills and knowledge to help startups be ready to enter our process, continues with preliminary screening by the staff, through the selection by our screening committee (the 10-15 most experienced angels in our group), and finally the presentation to our members who invest in good deals. This process is both efficient and respectful for both angels and entrepreneurs. And, it is complemented by a rather extensive knowledge base of market terms, deals and conditions. All of this leads to great companies, presenting well to our members, and being prepared for due diligence and investment.
  2. Get the deal terms right. We work with entrepreneurs to set terms and valuation that are deal and market appropriate, which allows companies to endure. In the past, too often investors didn’t understand the impact of setting a price too high, raising too much or too little money, and/or having either investor or entrepreneur-unfriendly terms. While they can often be seductive at the outset, bad terms lead to long-term problems at companies. The AoA has taken a lead role in the Pacific Northwest in bringing forward deals that make sense for both investors and entrepreneurs. By setting terms correctly, companies can survive and thrive even after market or strategic problems push the company off track.
  3. Active, engaged investors. The AoA members not only write checks, but often get actively involved in the companies in which they invest and often take board seats. As a group, we bring a ton of knowledge and experience – the kind of experience that many startups couldn’t afford or acquire any other way. This knowledge often helps our portfolio companies avoid mistakes, see them earlier, or find more innovative solutions to fix them. We are also a source for follow on rounds, especially at this time when VC financing is either not forthcoming or inappropriate. This pool of active, engaged investors helps companies survive and thrive.
  4. The right strategy, done early enough to make a difference. About 4 years ago, we realized that our investment results then were mostly dependent on a few of our most active members investing in a lot of companies, but this wasn’t sustainable. We realized that we needed to increase the “capital capacity” of the group, if we were going to remain relevant. We were fortunate to ride the trend of the “professionalization of angel capital,” where individual angels realized that working together led to better results. Over the last four years, we have succeeded in (a) reformulating our strategy, vision, and mission, with a rebranding of the AoA; (b) recruiting a continuing stream of new members; (b) putting in place education programs that help our new and existing members know how to do good deal; (c) putting in place an angel term sheet (http://drosenassoc.com/Draft%20Term%20Sheet%20for%20Alliance%20of%20Angels.pdf) that helps angels get deals done quickly and at low cost; (d) train our angels to be good deal leads, board members, and investors; and (e) be an advocate for better communication from startups to their investors.

While the ultimate measure of success is a positive return through lucrative exits, we also know that for these early-stage startups have a long period to exit – typically 7-10 years. Since our data prior to 5 years ago isn’t very good, our surrogate measure is the “J Curve.” The fact that the AoA has succeeded in dramatically changing the J Curve implies that the strategy is working.

Comments welcome.

The changing nature of communication

In my lifetime, I have witnessed the transformation of communication. When my grandparents were born, electronic communication meant telegrams. A couple of generations earlier, sending a letter from new York to san Francisco required writing a letter, getting it on a ship, and having it sail around South America, taking months. In rapid succession, we deployed railroads, telephones, highways/cars, airlines, data networks, and the Internet. The result is we can now send the same information that required months in less than the blink of an eye.

But, one aspect of this communication remained the same – you needed to know who you were communicating with and their address.

In the last few years, this has all changed! We can now communicate, individually or to a group, with people who we don’t know. The rise of social networks allows people to find others that they don’t know, but with whom they share an interest – around the world! This has changed the definition of community. And the definition of “friend.”

I think it will take many years to understand all of the impacts of this profound change in communication.

At the tip of the iceberg, we see the revolts in the Arab world in North Africa, where dissenters used Facebook to organize and communicate.

I saw the precursor of this in Eastern Europe and Russia (actually the Soviet Union) in the late 1980s. When visiting frequently on business, some of my colleagues would ask me to bring blank video tapes (pre-recorded video tapes were seized on entry!). I didn’t understand this at first, until I was taken to a “secret” video exchange market, where you would bring a blank video tape and pay some money to get a current-run Western movie. It gave the populace the ability to see Western culture, values, etc. I believe it was a contributing factor in the changes that later swept that part of the world. The Internet and Facebook is a much more potent force for knowledge, freedom, and understanding.

We live in a time of sweeping change.

Seattle Alliance of Angels has a terrific 2010

The Seattle Alliance of Angels had a wonderful 2010. To quote the headline: Alliance of Angels Invests Record-high $10.3 Million in 2010; Group hits new milestone with investment in 33 Northwest-based startups; surpasses previous investment record by more than $1 million.

I was quoted:

“Once again, our angels have set a new standard for investing in innovative, young companies,” said Dan Rosen, chair of the Alliance of Angels. “For the second year in a row, AoA has cemented our position as the most active angel organization not just in Washington, but in the whole of the Pacific Northwest.”

“What is especially gratifying,” he continued, “is that 95 percent of our members have made at least one investment in the past two years. Even as the economy struggles to rebound from the recession, our members continue to support the AoA portfolio with initial and follow-on investments.”

“That is a testament to the quality of our deal flow, the value of our screening and coaching, and the eagerness of our investors to support entrepreneurs with promising ideas.”

Seems that angel investors are once again full of hope for the future.

See full release: http://drosenassoc.com/AoA%20results%202-23-11.pdf

Apple: You’ve Got to be Kidding

I hope that you all have been following the tiff that has developed between Apple and its app vendors and publishers (see e.g. http://www.informationweek.com/news/personal-tech/smart-phones/showArticle.jhtml?articleID=229200215). Nothing like taking wonderful successes like the iPhone and iPad and then let unbridled greed kill an ecosystem. This is exactly the kind of corporate behavior that has killed so many nascent new markets and deserves to be punished.

As those that have read my previous blogs know, I am a big iPad fan. Among my favorite apps on the iPad are Kindle and Netflix. I was proud of Amazon for sticking up to the publishers to try to get better pricing for their customers, even though they ultimately failed. (Can anyone explain to me why a printed book should be cheaper than an eBook?)

The only logic behind Apple’s decision that ALL content offered through their platform should have to pay them 30% of the gross is that they think they can get away with it. The end result will be one of the following:

1) The content providers will have to charge 30% more on Apple platforms; or

2) There will be less content available on those platforms, because all content will only be available on the iTunes store.

Neither of these alternatives is good strategy for Apple. While exceedingly profitable in the short term, ultimately, it will lead to their ecosystem being stifled of innovation and being surpassed by others that are friendlier to partners and user economics.

I believe that Apple is still thinking like the underdog in its markets and not like the market leader it has become.  Being the market leader brings obligations as well as exceptional rewards.  If Microsoft were to decide to charge a 10% charge for all e-commerce done on Windows, the furor would be loud and never end.  But Apple, with its innovative products seems to believe that it is still the underdog and not the market leader with iPad and iPhone.  It is exactly this sort of bad corporate greed that forces governments to become involved in our industry (see http://online.wsj.com/article/SB10001424052748704657704576150350669475800.html?mod=WSJ_Tech_LEADTop). I hope that Apple senior management and their board wake up soon.

I would urge all iTunes customers to immediately find alternative way to buy content. A good example of this is one of my portfolio companies – Single-Click Checkout (http://www.singleclickcheckout.com/) which is available to merchants on most mobile platforms and allows a user a safe and secure way to purchase things directly from the vendor on their mobile devices without using the platform store.

I hope Amazon and other content owners don’t bow to Apple’s mafia-like tactics. Even if Apple doesn’t realize it, forcing their hand on this and getting them to back down is in everyone’s interest.

I had waited to upgrade my iPhone 3G to an iPhone 4 on Verizon, and was just about to do so.  I no longer intend to go to the iPhone 4 with this Apple policy on content.

Technology & Revolution

I admire Thomas Friedman’s intellect. In today’s NYT, he wrote a particularly insightful analysis about the events in Egypt and the Middle East, called China, Twitter and 20-Year-Olds vs. the Pyramids (http://www.nytimes.com/2011/02/06/opinion/06friedman.html). Like in many of the revolutions that swept Eastern Europe, there is clearly a link between modern communication technologies that were spawned by the Internet and the ability of people to quickly gather around key societal issues. This was one of the original promises of the Internet. Like with many technologies, we often overestimate their progress and impact in the next two years, but underestimate their impact in ten years.

Social networks are one of the first communication media that allow like-minded people to communicate without knowing each other. In the past, you had to at least know someone’s address (physical or virtual) to send them a message. This is no longer true and the vast societal impacts of this will reverberate for decades. I saw this first hand when I was in charge of AT&T’s communication businesses in Eastern Europe in the late 1980’s (even having the good fortune to be in Berlin on the day the Wall was opened.) Even then people realized that communication was a necessary ingredient for change.

But Tom takes this a step further. He points out that “the whole Asian-led developing world’s rising consumption of meat, corn, sugar, wheat and oil certainly is” fueling the revolts in the Middle East. What a fabulous insight about the interconnected global economy! Couple that with an increasingly educated and aware population of 20-year-olds who can now easily communicate their frustrations and gather on social networks – that’s fuel for change. Especially in societies where there are a great many of what Tom calls “the educated unemployables” that have college degrees on paper but really don’t have the skills to make them globally competitive.

It is axiomatic that most new technologies are generational. It is not surprising that the aging autocratic leaders of the Middle East (and elsewhere) at best have a limited understanding and therefore underestimate the impact of Twitter, etc. While those of us in the technology field know that none of these are revolutionary technologies per se, the societal impacts wrought by the wide-spread adoption of them are!

My Favorite Smart Phone Business Apps

(A press request)

First, it is impossible for me to separate my business and personal apps very well. Since the smart phone (currently an iPhone and iPad in my case) is an ideal vehicle to integrate personal and business, the apps tend to get used in multiple ways. My top 5 are:

  1. Kindle. The Amazon kindle app on the iPad and iPhone is my absolute favorite. I use it every day to read while on the elliptical trainer at the club.
  2. Netflix. The fact that you can now watch movies that stream live to your device is both amazing and breakthrough.
  3. WorldCard. This amazing app lets you use the camera on your phone to capture a business card and then transfer it to your Outlook contacts. Once someone hands you a card, you now have it available immediately.
  4. Skype. If you travel outside the US, it is no surprise how expensive it is to make calls on your cell phone back to the US. With Skype (and a good headset; mine is the Plantronics Discovery 975), coupled with the Skype $2.95/mo calling plan and a wifi hotspot, you can call anywhere in the US for free.
  5. Red Laser or Amazon. You are in a store and see an item you want to buy (yes, even business items). Are you getting a good price? Now just scan the barcode and voila, you know what you can buy that product for online and go ahead and either purchase it from the store or online.

Success! What happens now?

I am often asked: “my company has achieved its initial goal of getting to $1M in revenue and being cash flow positive. What now?”

In order to grow to be a $10M revenue company, we need to scale up sales and marketing, add new product lines, etc. We therefore need to raise $5M in the business and will need to raise if from institutional investors. When I project forward my cap table, I realize that I would be much better selling on the promise of where we are, if we can sell for a reasonable amount. The alternative: spending the next six months talking to investors instead of growing my business.

So what is a “reasonable amount?” Most businesses in this state (if they have been reasonably capital efficient) will have raised about $1M or so and have a post-money valuation of less than $5M. Therefore, even at a sale price of $5M, the investors could make 2x, if there is a 1x liquidation preference, and the entrepreneur will make $3M. The investors would get a 3x return if the company sold for $10M (if there is a 1x liquidation preference). At a sale of $20M, the return is spectacular.

But how does this happen?

One major problem is that is it exceedingly difficult to sell small companies to large acquirers. When I was at Microsoft and Bill still approved all acquisitions, regardless of size, he once chastised me for doing a $3M acquisition of a UW spinout tech company. “It’s just as much work as a larger one and your time is too valuable. Do bigger deals.” That was true then and even more true now with increased government regulations and widespread use of open-source software in the products that small companies sell (which causes enhanced scrutiny of the code base for any infractions).

But even more importantly, small companies that are angel-backed and therefore “capital efficient” (meaning run very cheaply!), don’t tend to build the same infrastructure that a company with more capital would build. This is what makes them such attractive angel deals. But it is also one of the root causes of what makes them difficult to acquire.

The typical first-time successful startup CEO will build a great product, get their initial customers on board, and build marketing and sales to sell that product. This is very different than marketing and selling a company.

Selling a company to a large acquirer necessitates several other factors:

  • A vision about the company’s importance to the acquirer that clearly shows where the initial product leads;
  • A coherent and believable business plan that clearly shows the impact of the acquisition on the acquirer, as well as the costs;
  • Clean legal and financial docs, prepared by experienced and believable people, so that the acquirer won’t have to spend six months in due diligence;
  • Well-documented IP and code, that allows for rapid due diligence;
  • A well-honed understanding for the acquisition process, its key touch points, timing, and sensitivities.

Generally, these things can be provided by the company management team, board, or paid advisors. But in small, thinly capitalized companies, they are missing more often than they are present.

Therefore, selling a small, but valuable, angel-backed company seems akin to selling a beautiful home by placing a “for sale by owner” sign in the yard and hoping people will decided to call and make an attractive offer.

Recent Posts

Tags

#startups AngelInvesting Angels Boards Covid-19 Funding Leadership New Normal Startup Heros Strategy