Category Archives: Investments

Modumetal and other category creating companies

I’m often asked about what I look for in startup companies. There really are two answers to this question.

On one hand, for most of my investments I seek a good solid company, with a great management team that can build a good revenue stream in an uncrowded market, which can be acquired at a good premium.

But the ones that get me really excited are those few, rare opportunities to define a completely new category with a world-changing technology. At any point in time, I like to have at least one such company in my portfolio and the current leading candidate is Modumetal (www.modumetal.com). Modumetal owns a category called nanolaminate composite alloys. In essence, they have found a way to make laminated metals that can take advantage of properties that occur at a nano scale. As you can read on their web site:

Modumetal is a new class of nanolaminated materials that will change design and manufacturing forever. Modumetal is going to change the way that engineers make parts, not just by affording the ultra-high performance of its nano-materials, but also by a process that we call Modumetal by Design™. This process allows engineers to bridge design and manufacturing to realize large-scale finished parts from nanoscale building blocks. Modumetal is a revolutionary nanolaminated alloy system that is stronger and lighter than steel AND can run longer and hotter than nickel-alloys AND is more corrosion resistant and costs less than stainless. Modumetal will replace today’s metals, ceramics and composites in applications, starting with military armor – proceeding to cars, planes, buildings and consumer goods. It is the next generation material that represents a sea change in the age-old tradeoffs between cost, weight and performance.

It is still early in the life of the company, so there is still a great deal of risk. The excitement of being part of company that can change the way things work may not be the most disciplined way to do angel investing, but it sure is what I enjoy. Stay tuned.

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.

Angel Investing in the Current Economic Environment

I recently was interviewed about the impact of the current economic environment on Angel Investing.  Since these are questions I’m asked frequently, here is the post. Reporter:  Are angels less willing to part with their money now? e.g. Angel investment was down 26% in 2008…what do you see so far in 2009? Dan:  There are two different categories of angels.  One is “fair weather” angels, who think it’s really cool to do some angel investing, but are more driven by environment.  The second are more “professional angels,” who understand that: (a) angel investing requires a long-term attitude – results don’t come quickly; (b) a portfolio approach is essential and one or a few investments is not a successful strategy; (c) the first investment in any company is rarely the last – you need to reserve for follow on rounds; and (d) “doubling down” on a good company leads to better returns, as does shedding a non-productive investment.  “Professional angels” continue to invest in down markets, knowing that the best returns are often made during these periods.Reporter:  Overall trends you’re seeing: e.g. investing more in existing deals? Giving more runway to portfolio companies? more disciplined approach to investing/how so? Dan:  I believe in a disciplined approach.  Create a portfolio and support your companies.  That discipline applies even more when markets are buoyant – maintaining post-money price at a level that won’t lead to later down rounds.  When exits are few and far between, the discipline is equally important – an investor needs to be balanced and not try to foist an unfair deal on an entrepreneur.  The entrepreneur also must be cognizant of market conditions and make sure that the are disciplined in the amount of money they are trying to raise, the value they give for that money, and the use of that money – efficiency is the key.Reporter: What will get an investors’ attention–now? e.g. have the type of companies you’re interested in shifted in anyway/how so? (green technology? distressed properties?) Dan:  Great entrepreneurs, building great businesses, with solid plans.  This is a constant.Reporter:  Benefits of launching in a down market e.g. for entrepreneurs: cost of starting a company is lower? more talent is available? e.g. for angels: reduced valuations/get more company for less? Dan:  In this down market, more talent is available at competitive prices.  This is good for startups.  For Angels, deal terms and valuation are also competitive, but as I said earlier, this should be reasonably constant.  The biggest difference is that VCs can no longer be counted on to finance startups that have made it through the seed stage successfully.  This implies that Angels will need to carry deals further – often to profitability, so deals.  This does raise the financing risk of many deals and also requires that Angels need larger syndicates and more reserves.Reporter:  How many deals do you/your firm evaluate in a year? month? is the number increasing/decreasing? Dan:  I look at about 15 deals a month.  This number has been pretty constant.Reporter:  How do the deals look right now? lots to choose from? less? (trying to gage to what degree the market is saturated or open)Dan:  This is a great time to be an angel investor.  It would be better if there were more positive exits.Reporter:  Getting to “yes”.  What does it really take for you/your firm to say “yes” to a deal today? How has that changed over the last 18 months? Dan:  Since financing risk has increased, capital efficiency (which was always important to me) has become even more critical.Reporter:  First impressions: how long does it take you to get to yes or no? why? what are you looking for…. Dan:  I will usually know in 10 minutes if I am going to do due diligence on a company and spend the next 90 minutes looking at it.  (This is the primary reason that the AoA does 10 minute pitches).    Then, based on the impressions of the company’s leadership, answers to questions, and their market/business model, I’ll typically do another day or two of due diligence to reach a decision, but those days might be spread over a month.  I am often influenced by who else is looking at the deal and will rely on their due diligence and experience.Reporter:  What are the top 3-5 reasons you say no to a deal? explain with examples e.g. what it is about a business model that you know won’t work…. Dan:  The main reasons for passing on a deal are: not capital efficient, insufficient confidence in the management team, no chemistry with the CEO, any hint of deception, too small a market, a management team that believes its own marketing more than the reality of the market (which will lead to many problems and surprises going forward).The main problem I see with business models is the inability to scale from the initial customer set to critical mass.  (Usually I hear words like “viral marketing” or other external ways to build market.  These rarely work.) Reporter:  Top 3-5 reasons you say yes to a deal? Examples?  Dan:  If I really like and admire the Founder or CEO, that gets me a long way to yes.  Then I need to see a large market potential, good plan to attack that market, and a good dose of realism.  And lastly, I like to understand how the company might achieve an exit.  Sometimes a company will meet the first criteria, but I can only see one path to exit – something I find risky.Reporter:  Explain your “feel for a deal”–what it is in your gut that tells you, this will work…. Dan:  The passion of the management team starts the process.  It helps if I understand the market.  And, of course, the ability to take what is a good idea and turn it into a good business.  Often I see great features, that might become a great product over time.  But rarely does a good feature/product make a great business.  That requires product lines that can hit multiple segments.Also, you often see entrepreneurs think about how to build their company to sell it to someone.  It is really important to build a great business and not focus too much about who will buy you.  That doesn’t mean you don’t think about potential exits – just that focusing solely on that rarely pans out.Reporter:  Advice: 5-7 tips to offer an entrepreneur presenting to you today….Dan:  I can’t manage 7 things at once.  But the #1 tip for an entrepreneur is: “tell them what you do.”  Too often an entrepreneur will want to educate me on how smart they are, or why what they do is so difficult.  Without the context of what you do, the rest might be interesting, but has limited relevance.  And remember that you are talking to investors, so your discussion has to be tailored to that audience.  And lastly, listen to questions – be willing to have a discussion and not present your slides.

Convertible Note vs. Priced Preferred Round

Convertible Note vs. Priced Preferred Round

 

The form of an investment is an on-going issue for Angel Investors and Startup entrepreneurs.  This post describes the differences between a convertible note and a priced round, the benefits of each, and recommendations for investors, service providers, and entrepreneurs.

A priced round is easy to understand.  Each investor in that round is told the price per share, and is issued shares (generally preferred) at that price.  Legal fees for a priced round are usually in the range of $25,000 to $50,000.  So for a small round, the legal fees can be a significant portion of the round.  Also, many entrepreneurs and investors cannot agree on the valuation of the company to set the price.  I believe that this is the wrong reason to avoid a priced round, because it is indicative of a deeper problem and fundamental disagreement between the investor and the company.  Would you buy a car, where you didn’t know the price till you had driven it a year?

Many lawyers recommend that startups offer investors a convertible note, a form of loan that converts to equity when the next round is closed, usually with some form of discount.  It is both quicker and incurs lower legal fees than a priced round.  In general, these notes are used to “bridge” a company between two funding events, e.g. between a friend/family round and an institutional round.  There are several key parameters in these notes.  They are outlined below (with what I consider average values in Seattle today):

1)      What is the term of the note?  This can range from 3 months to 18 months.  In general, most of the deals I see have a term between 6-12 months, where 6 is more investor friendly and 12 is more entrepreneur friendly.

2)      What is the discount?  This discount can take two forms.  One is a plain discount, where the investor gets a price per share that is less than the next investors.  The second, is the issue of warrants, where the investor gets warrants issued as a discount (e.g. 1 warrant for every 4 shares = 25% discount).  This is to some degree related to the term – the longer the term, the higher the discount.  It is rather common for the discount to increase with the term (e.g. 20% for the first 6 months, then increasing by 5% per month for the next three months).  Currently, the discount is about 20-30%.

3)      What is the interest on the note?  In general this is either prime plus some percent or a fixed percent.  Lately, I have seen 8% annual.

4)      Is there an assumed value?  This takes two flavors in the docs.  First is what happens if the company doesn’t raise its round before the term of the note.  For example, if the company issued a 6 month note, but didn’t raise its round, at what price does the note convert?  Usually, investors will insist on a price that is prevailing for the company at the time the note was issued.  This is often the last round pricing.  For Seattle startups, without a final product or customers, that is typically in the $1.5M to 2.5M range, but there is great variability depending on lots of factors.  The second flavor of the value is what will happen if the company is acquired before raising the round.  For example, if the company takes in a convertible note for $1M, but then sells for $100M before the conversion?  Unless otherwise specified, the investor only gets their principal plus interest (in this case $1M plus 8%), while entrepreneur gets the other $99M.  As an investor, I like to be aligned with the entrepreneur, so would set an assumed value in this case, so that the investor has their choice of either the principal plus interest OR conversion at a fixed value (say $5M) in this case.

5)      Does the investor get any say in the terms of the round? When the company raises their round, it might be at terms that the investor would never have agreed to, but rarely has the right to do anything about it.

So, in conclusion, investors like priced rounds, and usually fight for them.  Entrepreneurs often benefit from convertible notes.  If the note is short term and has reasonable terms, it’s not a bad idea.  However, there has been a trend for longer notes (more than 6 months), at a time when the next financing round is not pending.  In essence, this is the company asking the investor to put up their money to build value in the company so that they will then pay a much higher price per share.  As an investor, not something I’m inclined to do.

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.