Investments – Page 3

Save Angel Investing Amendment to Senator Dodds Restoring American Financial Stability Act of 2010

(With thanks to Bill Carleton and Joe Wallin)

High-growth startups are a cornerstone of our economy. Studies have shown that these startups account for much of the job growth in the US and are critical for America’s competitiveness. Angels who finance these companies often become actively involved and help the companies thrive. Angel investment in startups provides the primary and the best source of early-stage capital needed for startup tech companies and other innovative new businesses in America. Such investment is encouraged in many states and other countries.

Section 926

Section 926 of the Dodd bill would impose new, unwarranted and devastating restrictions on the “Reg D” process by which Angels (and Angel Groups) support America’s startup innovation economy. Moreover, as we explain below, these restrictions are wholly unnecessary: more-effective, more precisely-tailored reforms are available to fix the abuses of Regulation D that occur outside the Angel investing arena.

We do not believe that it is the intent of Sen. Dodd or Section 926 of his bill to do so, but a consequence of the current language in the bill would be to seriously impede angel investments.

Today’s process (Reg D) requires that startup companies funded by “accredited investors” (sophisticated business Angels who understand the risks in such investments) can invest without undergoing the expense, complexity and delay of a registration process. Instead, within a few days after the first sale, startup that has received the investment files a simple “Form D” notice filing with the SEC and with each state in which an investing Angel resides. This system has worked well for over 15 years, as shown by the growth of early-stage companies. Remarkably, there are virtually no examples of fraud or abuse in such angel investments.

On reflection, it makes sense that Reg D should work so well for startups and Angel investing. First and foremost, the startups in which Angels invest are not in the business of selling or trading securities. They do not engage broker dealers to do so, and they do not sell to the general public. Instead, these startups are placing securities directly in the hands of sophisticated Angels in order to obtain needed capital to get a new business off the ground. If the startups and the Angels are successful in what they set out to do, they will create jobs in the process and possibly returns on investment. Angels know the risks, going in.

In this vital process, the way that innovation in America is financed at the grass roots, no one is making a living or taking a profit from the process of selling securities. Startups are “incidental” issuers only, and all participants in startup “grass roots financing” (including entrepreneurs, Angel investors, and lawyers) have every reason to self-police. In the rare instances of securities fraud, the Reg D exemption notice filings serve a critical record-making function, just as they should: investors who feel cheated can sue to show how a Reg D exemption was claimed and filed falsely. If there was fraud, those investors are going to have recourse, personally, from the officers, directors and others associated with the rare problem startup. And you can bet the persons in those rare, fraudulent startups will not be supported again by the Angel community, nor should they be.

Section 926 wants to toss out this process that has worked so well and start over with a 120 day review period for all Reg D filings. For most early-stage startups, time equates to life or death and the regulatory review process proposed in Section 926 will kill many promising companies. For those of us willing to spend the time, expertise, and money to start potential high-growth companies, the changes that would be imposed by Section 926 seem unnecessary and counter-intuitive.

Section 926 also wants the SEC to define by rule a class of securities that are too small in size and scope to merit eligibility for the uniform, federal Reg D notice exemption system. But it is exactly the small, “seed” (getting a startup off the ground) financing that most needs the benefit of Reg D!

From discussions with Joe Borg (Director, Alabama Securities Commission, and Member, NASAA Board of Directors) and others, we have come to understand that the States, as a part of financial system reform, have been plagued with certain disreputable promoters, brokers, dealers and investment advisors (“bad actors”) defrauding investors by abusing Reg D filings. The State regulators have the authority to prosecute, but feel they are hamstrung by being able to do so only after the fact when the money is already gone. The primary intent of Section 926 is to give the States the ability to regulate these “bad actors” before they are allowed to take in funds under fraudulent terms. Angel investors and groups share this concern and would like to suggest a solution to the State Regulators’ problem that does not restrain Angel investors (or Angel groups) from creating high-growth startups.

There is a valid need to regulate promoters, brokers, dealers, and investment professionals that raise money for others. Attached you will find a suggested amendment to Section 926 that achieves the following:

Address the concerns of State Securities Administrators by:

Eliminating federal preemption of state authority with respect to exempt offerings that that involve brokers, dealers, or investment advisers.
Instructing the SEC to amend Rule 506 of Regulation D, to incorporate by reference the disqualifications already in Regulation D that pertain to Rule 505, so that “bad actors” can’t abuse Regulation D.
Clarifying that existing state jurisdiction to investigate and bring enforcement actions with respect to fraud or deceit, or unlawful conduct, applies not only to broker-dealers, but also to investment advisers.
Disallowing the use of Rule 506 for offerings that are not “all accredited investor” offerings (current rules allow 506 offering with up to 35 non-accredited investors if certain information requirements are met).

Address the concerns of startups and angel investors by:

Eliminating the 120 day SEC wait/review period in the current version of the bill.
Eliminating the authority given to the SEC under the current proposed bill to establish, by rule making, a class of securities offering that would be too small to merit federal exemption, leaving in place the current, national, uniform notice-filing system for startups.
Clarifying that a security is a covered security with respect to a transaction that is exempt from registration under Rule 506, including with respect to groups of purchasers comprised solely of accredited investors.

We believe that this meets the needs of the State Regulators to clean up the industry without the chilling effect that an elimination of Reg D would impose on funding startups by accredited angel investor.

Furthermore, by eliminating the “bad actors,” we will enhance the ability to get new startups going investors will feel more secure in knowing that they are not investing in scams. This is a true win-win.

Section 412

Also of concern in Senator Dodd’s bill is Section 412, which would change the definition of an “accredited investor.” It is hard to argue that an individual with a net worth of greater than $1,000,000 is not a sophisticated investor. Section 412 would index that $1M back to 1982 and make the new definition $2.25M, eliminating 77% of the potential accredited investors (see Shane’s article in Business Week (http://www.businessweek.com/smallbiz/content/mar2010/sb20100318_367600.htm).

Section 412, in our view, is nothing more than a poorly conceived tool to limit the scope of broker dealers and investment advisers abusing regulation D. The tool is poorly conceived, because it is so indirect. In the process of eliminating three quarters of the population from which the fraudulent broker-dealers might operate, it also would devastate the single most important source for start up financing in America. And it would also prevent knowledgeable and sophisticated angel investors with high net worth (but not high enough) from receiving the returns that their richer brethren receive; this is neither fair nor democratic and, once again, not in the spirit of the Dodd bill.

As part of saving angel investing, if we make the protective changes to Section 926, we believe that we no longer need the protections suggested in Section 412 there should not be an indexing of the definition of accredited.

___________________

Amendment to S. ____
“Restoring American Financial Stability Act of 2010”
Offered by ____________

Page 816, strike line 3 through page 819 line 4 and insert the following:

SEC. 926. AMENDMENTS OF RULE 506 UNDER REGULATION D ; AUTHORITY OF STATE REGULATORS OVER REGULATION D
OFFERINGS INVOLVING BROKERS, DEALERS, AND
INVESTMENT ADVISERS.

Section 18(b)(4) and Section 18(c)(1) of the Securities Act of 1933 (15 U.S.C. Sections 77r(b)(4) and 77r(c)(1), respectively) are amended

(1) by inserting, following subparagraph (D) of said Section 18(b)(4), a new subparagraph (E), as follows:

“(E) Rule 506 under Regulation D, provided that all purchasers with respect to such transaction are accredited investors, as such term is defined in the rules of the Commission under the Securities Act of 1933, or are persons, entities or groups composed solely of accredited investors purchasing securities solely for the beneficial interest of said accredited investors.”

(2) by redesignating paragraph (1) of said Section 18(c) , “Fraud Authority,” as subparagraph (1)(A) thereof, and restating it as follows:

“(A) The securities commission (or any agency or office performing like functions) of any State shall retain jurisdiction under the laws of such State to investigate and bring enforcement actions with respect to fraud or deceit, or unlawful conduct by, a broker, dealer, or person associated with a broker or dealer, or an investment adviser, or persons associated with an investment adviser, in connection with securities or securities transactions.”

(3) by inserting, following such redesignated and restated subparagraph (A) of said paragraph (1) of Section 18(c), a new subparagraph (B), as follows:

“(B) A security is not a covered security with respect to a transaction that is exempt from registration under this subchapter if the offering of such security involves the payment of any commission based on funds raised by the issuer in connection with such offering, or otherwise involving a broker, dealer, person associated with a broker or dealer, or involving an investment adviser who has a financial interest, direct or indirect, in the offering of such securities, or a person associated with such an investment adviser.”

(4) by inserting, following subparagraph (D) of said Section 18(c)(2), a new subparagraph (E), as follows:

“(E) AVAILABILITY OF PREEMPTION CONTINGENT ON LACK OF DISQUALIFICATIONS. The Commission shall amend, by rule, Rule 506 under Regulation D, to disqualify securities issued in reliance on said rule as covered securities under Section 18(b) of the Securities Act of 1933, for reasons which are comparable to the disqualifications currently set forth at subparagraph (b)(2)(iii) of Rule 505 of Regulation D.”

Taking Money from Entrepreneurs Pockets

In a previous posting/rant, I talked about Angel Groups that gouge entrepreneurs (http://blog.drosenassoc.com/?p=13). Some charge over $10,000 for the right to present and that steams me. However, I have not directed my wrath at another group that gouges entrepreneurs even more brokers and small investment bankers. Note to entrepreneurs: Do Not Use a Broker (or small investment bank)!

Such firms typically charge an entrepreneur between 5-10% of the amount raised, in addition to expenses, legal fees, and a retainer. No angel I know wants to see the money they invest in a startup flow out the back door in this way. You do not need to pay to find angels and get them to invest in your company. If you have a good idea and a good business, approach us directly. The staff at the Alliance of Angels gives you far better feedback, based on angels who actually invest, than you will get from a broker. And it’s free!

The Northwest Entrepreneur Network (NWEN) and Washington Technology Industry Alliance (WTIA) offer seminars, networking events, and classes on how to raise money. They are low cost and valuable.

But.. no angel I know likes deals where there are brokers involved. We like to meet with and get to know the entrepreneur, help them get their company going, and build to a success. None of want or need someone in the middle.

Senator Dodds attack on Angel Investing

Senator Dodd decided to take on an overhaul of banking regulations. In his massive 1300+ page bill (http://banking.senate.gov/public/_files/ChairmansMark31510AYO10306_xmlFinancialReformLegislationBill.pdf), he has slipped in an attack on angel investing. It would impose burdensome and unnecessary new legal and regulatory requirements on startup companies raising angel financing. A recent post by Joe Wallin and Bill Carlton on TechFlash (http://www.techflash.com/seattle/2010/03/congress_attack_on_angel_financing.html) outlines the issues.

My comment:

The Alliance of Angels, through it national trade association, the Angel Capital Association, has been lobbying against similar proposals for the last two years. Sen. Dodd’s bill is by far the most serious threat to angel investing in quite some time.

The change in definition of accredited investor will cause many smaller angels to no longer be accredited. Particularly when angels work in groups like the AoA, the amount they invest in a deal might be small. Limited the capital capacity of a group like ours to help “protect our members” is both silly and dangerous.

But as Joe and Bill point out, the most troublesome part of the proposed legislation is inserting a new level of regulation. Many speculate that Sarbanes-Oxley killed the IPO market for small companies by imposing a new layer of regulation and cost on small companies. Sen. Dodd’s proposal to have the SEC and state regulators involved in angel financing is misguided. Very few startups can afford a 120 filing hurdle – they will run out of cash and go under. This is just absurd.

We urge everyone to write both of our Senators and your congress person to have these provisions removed and save angel investing.

Please act now!

Different Sorts of Energy Companies

There are many types of “green” companies or companies that help save energy. I have two contrasting companies in my portfolio that illustrate this well.

The first is Virticus (www.virticus.com), whose products and services allow owners of lighting solutions to reduce energy and maintenance costs by 30-50%. They sell to parking lot owners (e.g. shopping centers) and cities (for street lights). The Virticus communication and control system enables the management of lights individually and collectively. It is a really cool solution that has begun to get traction in the marketplace. This kind of combined software, hardware, and service solution can make a rapid and substantial difference in energy consumption.

The second is Modumetal (www.modumetal.com). I have written about Modumetal’s technology and potential before. One of the founders of Modumetal, John Whitaker, gave a recent interview (http://www.pfonline.com/columns/0210end.html) about their novel, nanolaminated Thick Thermal Barrier Coating (T-TBC) technology and its application for higher operating temperatures to improve diesel engine performance, give better fuel efficiency and lower emissions and noise. The Modumetal T-TBC will insulate critical engine components such as piston crowns, valve faces, and cylinder heads. This is expected to enable higher operating temperatures and protect against abrasion and temperature-accelerated degradation in diesel engines. It is innovation like this that is likely to have huge impact on energy consumption.

While neither of these are the kind of companies that one typically thinks of when you hear about energy or green companies. But these two companies point out that we should change our thinking.

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 Ive 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 entrepreneurs 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 Im 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 its 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 dont 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 wont 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 companys leadership, answers to questions, and their market/business model, Ill 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 doesnt mean you dont 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 cant 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 didnt 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 doesnt raise its round before the term of the note. For example, if the company issued a 6 month note, but didnt 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, its 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 Im 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. Lets 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 companys exit look like to get a venture return of 5-20x? Lets 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 thats 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 dont 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 wont 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.

Lets 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 isnt 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.

Dan Rosen