Early Stage Company Valuation

To outside observers, it sometime seems that investors are very lucky when they get an exit and make a spectacular return. Those of us who invest regularly in startups, and then take an active role, know that there is a great deal more than luck involved. It’s really hard to have a startup survive to get to exit. There is no formula, nor is there an algorithm to follow that makes this so. Would that it were so! If you drive your car by looking intently in the rear-view mirror, you will know with great precision where you have been, but are unlikely to avoid the truck that is driving straight at you.

But.. there is one thing that is generally predicative of success – valuation. If the valuation is set too high, you risk crashing on a down round when the inevitable happens and things that can go wrong, will go wrong. If you set the valuation too low, then the entrepreneur owns too little of the company to be incented; and follow on rounds with new investors is difficult because ownership is too concentrated in the hands of the early investors.

From both the entrepreneur’s and Angel’s point of view, it is better to grow the valuation steadily (and most usually slowly) than to have a high valuation at the start and then not increase the valuation later. Raising money is difficult at best; it becomes ever more difficult when valuation expectations are not aligned.

So, I make the following three recommendations:

  1. Balance, balance, balance. It is critical to understand the amount of capital that must be raised in the first round, what milestones that money will attain, and if that is sufficient to achieve the following round. Some businesses are just not financeable by Angel investors. If, for example, if your company really needs to raise $2M to ship your product that only addresses a potential $10M opportunity, you are unlikely to raise that money. And.. raising only $250k with the hope that, before you hit a meaningful milestone, you will later raise more is not fair to you or your investor.
  2. Try to project capital needs for future rounds (yes.. I know that most plans say this will be the ONLY money that the company will ever need. But I can’t think of an example where that was actually the case). Understand that each new investor in these future rounds will expect that their investment will lead to a good return – in short a good deal. The existing investors will like their investment to grow; they took a risk on the entrepreneur and the company and would like to see value commensurate with the risk they took, especially if you need them to continue to invest. And lastly, the entrepreneur team wants to maintain a reasonable stake that can lead to a good value on exit. While this is hard in the initial round with only one set of investors and the entrepreneur team, it is much more difficult when there are also new investors joining the process.
  3. Know the market. Angel Groups, like the Alliance of Angels, see a lot of deals and know what Angels consider a fair valuation for the risk and reward that those companies present. There is a market for Angel financing of startups. And, like any market, supply and demand matters. Seek advice on valuation from trusted sources, but weigh the advice heavily towards those that write checks to startups. We often ask entrepreneurs how they came up with their valuation. The most common answers are: (a) my lawyer told me that was fair; (b) I looked on the Internet to see what bloggers were suggesting; and/or (c) I build an excel spreadsheet that shows the valuation after we are successful and did a backward projection. While all of these methods have merit, they rarely lead to a true market-based valuation that leads to a quick and successful financing. While it is no fun to explain to an entrepreneur that the current value of their company is significantly less than they believe it should be, this is why “professional Angels” have become a trusted source for setting fair valuations.

In summary, the best way for an entrepreneur and Angel to agree on valuation is to see the deal from each other point of view.

More startups fail because of poorly set initial valuation (both too high and too low) than almost any other cause. This is an easy problem to solve, but it must be solved up front. We are lucky to have professional Angel groups that are willing to work with entrepreneurs to help startups succeed.

Crowdfunding

Crowdfunding is about to be approved by Congress and signed into law by the President. For those unfamiliar with the concept, you can read Wikipedia (http://en.wikipedia.org/wiki/Crowdfunding) or simply put it is raising money for startups, typically via the Internet, in small chunks from people who may never meet with or diligence the company. Crowdfunding has been used in some non-profits for years and has been successful in Europe for the last two or so years as well.

Most existing investors in this early-stage asset class hear of crowd funding and have the immediate reaction: “Won’t this lead to massive fraud?” Today, investments in unregistered securities require that all investors be “accredited” so that they are assumed to understand the risks in these investments and ensure that sophisticated investors carefully vet deals to ensure that there isn’t fraud.

But, times change. Some VCs and Angels have become fabulously wealthy and famous by investing in early-stage companies, and the media has made a big deal about this. Think Google, Facebook, and even Microsoft. And, in our current economic malaise, creating high-growth, innovative startups is seen as a way out of the mess. But many innovative startups fail in trying to raise money. Angels do their part (see many of my previous posts). But many believe that the need is greater than sophisticated (“accredited”) Angels can finance.

So.. the idea of Crowdfunding has gained great momentum. The current vehicle, H.R. 2930, the Entrepreneur Access to Capital Act, as amended and approved by the House Financial Services Committee on October 26, 2011, (see http://financialservices.house.gov/UploadedFiles/hr2930ai.pdf for the original). The amendments are important, since they lower the size of the amount raised. While the situation is still fluid (the House reportedly just passed its bill and the Senate is in draft), it appears that there will be a $1M annual cap on raising money through Crowdfunding. Crowdfunding is exempt from current broker-dealer rules. Other issues, like how companies handle scores or hundreds of investors or allowable fees that Crowdfunding platforms can charge, remain up in the air.

I have heard rumors about this being done in Europe for the last several years, but cannot substantiate that startup companies have been funded this way. Wikipedia reports that “One of the pioneers of crowd funding in the music industry have been the British rock group Marillion. In 1997 American fans underwrote an entire U.S. tour
to the tune of $60,000, with donations following an internet campaign…” And movies have been known to use Crowdfunding. Any readers with more data?

This is a brave new path for the US. While many (myself included) think that our current SEC regulations that limit investments in startups to “accredited investors” are too narrow and should allow other knowledgeable investors to participate, there is established law and precedent for the investment market. I worry that we might be opening Pandora’s box. Many startups fail and investors that are not willing or able to do due diligence should not be investing in them. It is one thing for sophisticated, accredited investors, like me, to invest in a company and loose their investment. We understand the risk going in. We did our due diligence on the management team, the market, and the technology and reached a positive conclusion. It is quite another thing for someone to “advertise” a deal to the Crowd and have people send them money based solely on the company’s information without any substantiation.

I believe that broadening the participation in the early-stage asset class is a good idea and Crowdfunding is one way to achieve this. I just don’t want some bad actors who use the Crowdfunding mechanism for fraudulent transactions to poison the entire asset class. I think it would behoove both the entrepreneurs that raise money with Crowdfunding and the investment community to find a way to have a trusted platform that verifies that the company is who they say they are and that some investment professional has done due diligence appropriate to the investment.

I also worry that Crowdfunding could lead to some very high priced deals. Investment professionals (including “Professional Angels) have a great deal of experience setting the price for early stage deals. This experience comes from many years of investing, forecasting companies’ success and capital needs, and understanding how exits are likely to occur. Without this discipline, prices might not reflect true value. For example, if an entrepreneur is told by the investment professionals in their community that an appropriate valuation for their company is $2M, but they go to the Crowd with a $10M valuation and raise $500k, what happens when they need to do their next round? After they have spent the $500k, they might approach either Angels or VCs who will then set the price well below $10M. The Crowd will then find that their investment is worth very little. If the Crowd understands that risk, I have no problem with Crowdfunding, but if this isn’t transparent or well-disclosed, I think we could have many disgruntled investors.

I really want Crowdfunding to work. I don’t want a bunch of “mom and pop” unsophisticated investors ripped off.

Why Cloud Computing Is Happening Now

Sometimes things just happen. But rarely do they happen without many antecedents. And rarely do we see the antecedents until after they happen.

I believe that Cloud Computing has followed this pattern. The obvious antecedents are Moore’s Law (http://en.wikipedia.org/wiki/Moore%27s_law), the rapid drop in disk prices, the proliferation of virtualization, and the emergence of large, efficient datacenters. Much has been made of all of these factors.

One that isn’t mentioned is the network capacity required to move vast quantities of bandwidth required to move the huge amounts of data from customers to datacenters and between datacenters. The networks have a long lead time to install. And require vast sums of money. Think about digging very long trenches and laying fiber optic cables between cities. And then each of the cities need to be hooked up with fiber. This is outrageously expensive, especially when you consider that rights of way and approvals need to be acquired, etc.

Given that the lead time for installing these networks was decades and we didn’t know that cloud computing was going to be a key application, how did these networks get installed to be there when we needed them?

I think the best answer is bad business decisions. Wait … did I just say that? Cloud computing is a key technology for the future, so how can it be a bad business decision? At the time vast quantities of network infrastructure we being put in, the Internet was in its infancy and doubling in size every 90 days. Companies (like WorldCom, Global Crossing, and MCI) decided to install capacity at a fever pace. And then the bubble burst in 2001 and the companies had a ton of stranded capacity and many went out of business. But the capacity remained, and at lower cost basis when acquired out of bankruptcy. Sometimes decisions made for one reason in one era have massively positive consequences in another.

Should Entrepreneurs Pay Angels?

Should entrepreneurs be asked to pay angels and angel groups for the opportunity to present their business?

As the seed stage/angel asset class becomes more prominent and popular, this becomes an ever more frequent question. There was a blow up about a year ago when Jason Calacanis took on the Keiretsu Forum and the amount they charged early stage companies. Not much has changed, but the number of people trying to part the entrepreneurs from their money has done nothing but increase.

Let me start with my emotional answer. It is hard for me to understand why an entrepreneur who has quit their job, mortgaged their home, and gone “all in” on their startup should pay a bunch of rich people for the privilege of pitching their deal. It just seems wrong. And, from my point of view, not something I would do.

But, if I take an entrepreneur’s point of view, I need to raise money. It’s such a daunting task and many entrepreneurs really neither have the time nor resources to pull it off. So, unless I see an alternative, if someone offers me a path to raise money, I take it. If I have to pay $10-25k to raise my needed $500k, I probably take it. I don’t ask questions like:

  • “Are the investors coming in aligned with our strategy?”
  • “How many investors are in my deal?”
  • “What impact do they have on my structure?”
  • “Do the deal terms mesh with raising more money later?”
  • And perhaps most importantly, “If I take this money, does it eliminate other sources, especially if I pay a fee to a broker?”

Experienced, professional angels have been through this lots. Groups like the Alliance of Angels don’t charge a fee for raising money for entrepreneurs. We help get deal terms that are fair to both entrepreneurs and investors, and allow for the necessary future financings (even when the plan says there won’t be any other financings).

It is hard to clean up the mess from a poorly constructed and overpriced financing. Most investors won’t do the clean up and instead will just pass on the deal.

Carve Outs for Management in an Acquisition

Carve outs for management is a tool that is often overlooked by boards in angel-backed companies. It is a tool that can be a critical in making an acquisition occur, but is difficult to get right. First of all, both management and the board are often too close and emotionally involved to make a clear decision.

For those that aren’t familiar with the concept of a carve out, it is a payment to management, from the proceeds of a transaction, that is paid out before investors are paid the amount they would otherwise be due from the sale of the company.

Having served on more than my share of boards, and often on the comp committee, I am often asked about the following situation, which is typical of one where a carve out occurs:

  • 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 from serving on dozens of boards and many comp committees:

  • It was management’s sweat that got the company to exit. This needs to be rewarded.
  • On the other hand, the board needs to recognize that management did not deliver the value that was promised when the money was taken. (Nor did the board.) It is not fair to give management a great return, while investors lose money.
  • 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 more of the proceeds to go to investors.
  • One often hears that management is unwilling to allow a deal to proceed if they don’t make enough money. And therefore they would rather the company stay in operation, even if it means a greatly reduced valuation. If the original deal terms don’t either carry enough voting shares, or the rights to force the sale, then the investors might be screwed. This is why alignment with the entrepreneur and deal terms can matter.
  • Finding a fair solution is often difficult. Hiring an experienced person/consultant might be a good idea, if the board and management are willing to follow their dispassionate advice.
  • 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!

Alliance of Angels Needs a New Managing Director

One of the good things about the steady success of the Alliance of Angels (www.allianceofangels.com) is the visibility it gives the Managing Director to virtually every deal in the Northwest. However, this also means that the AoA Managing Director is a highly sought-after professional. Our current managing director, Greg Huey, has decided to move on to become the President and COO of Glassybaby (http://www.glassybaby.com/). While we are exceedingly sad to see Greg leave, we are delighted that the Seattle startup community has a new and competent executive. Over the last two plus years, Greg has ably driven the AoA program to new heights, contributing to innumerable companies and making sure the very best were well represented to the AoA. The AoA set new records for annual investment in two successive years with Greg at the helm, a significant achievement while simultaneously navigating the organization through the economic downturn. We look forward to building on the progress AoA has made under his leadership. Greg leaves AoA having firmly established our program as a national model for entrepreneurial investment. While he leaves some big shoes to fill, we are confident that the opportunity to work with one of the most active angel groups in the nation will attract a successor who will continue this great work.

So now it’s time to find Greg’s replacement. The ideal candidate should have several years of business experience, and have substantial knowledge of the investment business (especially early-stage investing) either representing a venture capital or other private equity firm. An MBA would be a plus. The job description can be found here: AoA Managing Director Job Description.

Please feel free to contact me (or send a resume) at dan@drosenassoc.com.

Dan Rosen

Willamette Valley

I recently spent a long and exceedingly pleasant weekend in the wine region of the north Willamette Valley.

First and foremost, the Black Walnut Inn (http://www.blackwalnut-inn.com/) in Dundee, OR was fabulous. It has only nine distinct rooms, each with its own character, but all wonderful. It looks like a Tuscan villa that overlooks the red-hilled vineyards.

My favorite restaurant was the Joel Palmer House (http://www.joelpalmerhouse.com) in Dayton, OR. Make a reservation, but only if you like wild mushrooms. The executive chef and owner is Chris Czarnecki, a fourt-generation restaurateur, who comes from a family of mycologists. Joe’s Wild Mushroom Soup, a homage to Chris’ dad, and Heidi’s Three Mushroom Tart, a homage to his mother, are both wonderful. Great wine list and great sommelier (who also recommended a number of the vineyards we later visited). If the weather is nice (as it was for us), eat outside in the yard, under the stars.

I wasn’t a Pinot Noir fan until this trip. I had thought of Pinot’s as too earthy for my taste, but learned of the huge variety of tastes from this varietal. My absolute favorite vineyard (the one recommended by the sommelier) was Witness Tree Vineyards (http://www.witnesstreevineyard.com/). Their wines are less expensive than many, but quality was excellent. Not only great Pinot’s (e.g. the Vintage Select and particularly the Claim No. 51), but also a surprisingly wonderful Dolcetto “Remari”, and not-to-be-missed Sweet Signe. Also visited several others: Bethel Heights, Christom, etc.

And, lastly, for a great quick lunch visit the Blue Goat in Amity. It’s a tiny place, with its own brick oven and a goat meat empanada that shouldn’t be missed.

What a great way to spend a long weekend away from Seattle, especially during a sunny weekend!

The Economic Crisis

A while ago, I blogged on the decline of Microsoft (http://blog.drosenassoc.com/?p=42). Lately, many people have asked me about the current debt crisis, followed by the S&P downgrade of US credit. There are striking similarities.

Until about 20 years ago, for over 200 years, the US has been in a building mode. We have created the economic engine that fueled world growth, established an education system that was the envy of the world, a climate and legal structure that allowed great entrepreneurs to create companies that were the envy of the world. Even when faced with extraordinary challenges, like the great depression or the world wars, we were able to overcome these challenges.

Just as with businesses, in times of plenty, it is incumbent upon a business (or society) to put aside for the lean times. (I won’t cite Biblical references here, but they are obvious.) Since WWII, we have had numerous times of plenty. In the late 40s and early 50s, as a county we hugely increased our infrastructure (think the Interstate highways), invested heavily in universities (which have been the envy of the world and fueled much of our entrepreneurial growth), and through the concomitant consumer spending, created a surge in our standard of living. Many of these improvements allowed us to weather some of the storms that followed. With confidence, we strode into space – landing on the moon, created the Internet and countless other platforms that fuel global innovation.

But, our generation seems to have lost sight of what is really important. We have spent with reckless abandon. We have made poor strategic decisions. We, as a society and management team (the political leaders we elected) made bad strategic decisions. If we were a company, our stock would be trading at record lows and our investors would be clamoring for a change of leadership. But we have lacked the will and foresight, not to mention the systemic governance issues that prevent truly innovative leadership from coming to power. We need to make changes in the way we are run.

We are negligent for not having done this in the US. And, despite politicians’ desire for reelection demanding that they give us a silver bullet, there is no silver bullet! It took 20 years to make this problem – 20 years of lack of political will to curb spending and live within our means. But, just as I suggested with Microsoft, there are reasonable long-term solutions.

From my point of view, the solution is to unleash the entrepreneurial spirit that is embodied in the startups. This is where the economic growth, job creation, and invigoration of our society can come from. In a very specific sense, legislation before congress, like Senate Bill S256 “American Opportunity Act of 2011” (http://www.opencongress.org/bill/112-s256/text), sponsored by Senators Mark Pryor and Scott Brown that gives a 25% tax credit to angel investors; when similar legislation was enacted in other places, dramatic increases in angel investing and increased tax revenues have resulted. Another example are the proposed changes to IRS Section 1202, exemption for gains on qualified small business gains, which will give 100% exclusion of capital gains for angel investment.

These actions will spur angel investing in those high-growth startups that will ultimately move the economy. While modest in cost, they could be large in impact.

HTC Thunderbolt

Based on my previous post on Apple and their business practices (http://blog.drosenassoc.com/?p=59), I decided to upgrade my iPhone 3Gs to a Verizon HTC Thunderbolt. Getting on a 4G network was another major draw, as was getting off of the poor-performing AT&T network, with its dropped calls, congestion, and poor signal strength in places that I frequent. This is my review. In summary, I can’t recommend this phone except for a small segment of users.

The screen was great – very bright, easy to read, and responded well to touch and typing. Sound quality was great. Processor is fast. Having a separate radio for the 4G network means that you can use your phone for data during a voice call. And the Verizon network is rock solid.

In the end, it was battery life that got me to return the phone and exchange it for an iPhone 4. Both the Verizon store personnel, and their phone customer care, are aware of this problem and tell me that HTC is also aware of it. At times (that seem uncorrelated to use, etc.), the phone seems to run some background processes that just plain drain the battery. I tried a couple of the battery management packages, turned off GPS and WiFi, etc., but none of them seemed to make a major difference. So, I resorted to leaving the phone plugged into its charger while near an outlet, and purchased a nifty remote battery back that would give an extra 15-30 min of life. The final straw was unplugging the phone at 10:30 AM and having the battery be dead at 1PM. Totally not acceptable.

Also unacceptable was the fact that neither HTC nor Verizon had any sync software ready for the Thunderbolt. I spent a ton of time trying to sync the phone with my music and photos, but nothing worked. I finally gave up and called Verizon support to learn that HTC had not yet released the sync software. Through more hard work, I got Windows 7 to recognize the Thunderbolt memory and was able to manually copy music and photos.

On the good side, the Verizon 4G network rocks! Super-fast when it is available, which is often is in Seattle. During my trip to San Diego, I found that I was often on 3G and sometimes on 1x. As a promotion, Verizon allowed the Thunderbolt to act as a WiFi hotspot. This worked flawlessly and also was really fast. All of this seemed to be a great glimpse of the future.

And, lastly, some Google Android quirks (also known as design features). This is a phone, right? Well, I expected to be able to tag phone numbers/contacts as favorites. Turns out this is really difficult. You need to add a category of favorites, then use a widget to display your favorites. And you can’t list both home and mobile – you have to choose one. All of this makes the concept of “favorites” for calling or texting pretty lame.

Another quirk: the calendar. Unlike the iPhone, the Google calendar app does not allow for time zone support; it automatically resets calendars to your current time zone as determined by the phone. In other words, if you travel from Seattle to the East coast and book an appointment for 10 AM after your arrival, the Google calendar will change the time to 7AM when you arrive. While this is useful, if you are using outlook to coordinate a number of people in different time zones, it should be an option!

There is lots more I can add about both the phone and the experience, but I really can’t recommend the Thunderbolt until the battery life problem is resolved, unless you don’t need to be disconnected from power. But, if you fall into that category, you probably don’t need a cell phone!

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.

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