Friday, July 24, 2009

Raising Capital: Liquidation Preferences

One of the "standard" terms in VC term sheets is the liquidation preference. Google it, learn it, love to hate it and learn to live with it, because it's unlikely you'll get a deal without it. I call it the "have-your-cake-and-eat-it-too clause for VCs".

Here's how it works (or, How 20% becomes 28% without even trying).

Let's say you raise $1 million from a VC at a miraculous $4 million pre-money valuation. Your post-money valuation is $5 million, and the VC stake is 20%. The next week you sell the company for $10 million (because you're so amazing). How much does the VC get?

$2 million. Wrong! Yes, but 20% of $10 million is $2 million, right?

Well, yes and no. The liquidation preference means that the investor gets the$1 million back first, leaving you with $9 million, and then you take 20% in addition to the initial investment, making it $2.8 million total, or 28%.

So instead of merely doubling its money, the VC firm has almost tripled its money, with 180% return.  And that's only if you have negotiated a 1x liquidation preference; 2x and above are back in fashion given the economic collapse and the pound of flesh investors are trying to extract from their portfolio.

If you have a 2x liquidation preference, the VC gets $2 million, then 20% of the remaining $8 million, for a total of $3.6 million or 36% of the deal, leaving you with $6.4 million, just $2.4 million more than your pre-money valuation and only $1.4 million more than your post-money valuation. In fact, the VC gets the bulk of the gain in that case.

So before you sign the deal, you might want to consider whether it's worth it, because you could perhaps as easily (it's not guaranteed) sell the company for $7 million and do better than if you sell for $10 million with VC on board.

So why do liquidation preferences exist?

Primarily, this term is designed to give the venture firm downside protection. Let's say you sell for $2 million and your liquidation preference is just 1x. The VC firm gets its $1 million, plus 20% for a total of $1.2 million, leaving other shareholders with $800,000 to be distributed. They've still made 20%.

If you sell for $500,000, though, you get nothing, the VC gets $500,000, and has lost 50%.

I've always been ok with liquidation preferences as a downside protection, but I don't like it when venture firms get the preference when they are already getting a positive return on investment that matches their internal targets.

I'm guessing the term was introduced for downside protection, but somewhere it turned into a nice bonus for the VC firms and nobody challenged it, so it became standard. I 'm not a fan of standard.

WHAT CAN YOU DO?
Accept the terms, but limit participation to a certain level. Set a limit where the liquidation preference goes away--if the sale is greater than $10 million, they can choose the preference or the percentage, but not both. They will not likely agree to that number (my numbers here are arbitrary), because they want you to have extra incentive to push the number as high as possible.

So how much is enough? Well, first of all, if you only have one firm pushing a term sheet at you, you don't have a lot of strength to negotiate besides your ability to appeal to their belief in you and their reasonableness. When you talk about any term, suggest an alternative and say it's "fair and reasonable"--nobody likes to be considered unfair and unreasonable. But make sure the alternative matches the rhetoric.

Id' say doubling their money is reasonable. They'll disagree. Suggest an exit level that is 3X the post-money valuation (Keep in mind I'm not saying a 3x liquidation preference, but a 3x post-money exit. The difference is huge).

Liquidation preferences aren't likely to go away, and it's unlikely you'll negotiate them away. But you can contain them in a way that feels to both you and the VC that your interests are aligned.

Please comment on this if you have other insights, questions, corrections, or challenges.

Friday, July 17, 2009

Founders

I'm a serial founder, and am starting two tiny efforts at the moment in separate companies with a few people I know while continuing to coach startups (which is fun, if not highly profitable). The ideas are mine, but I'm a lousy coder and want great software, and don't have a lot of money to invest, so it's a joint effort with a bit of skin in the game by everyone in the form of sweat equity. Not equally a joint effort, though.

Deciding who and what a founder is at the beginning of a business is critical. Sometimes it's clear--the business is a going concern, you've invested your time and money, taken all of the risk, and hire a few people who don't take those risks or make those investments, and you're the founder and they are employees. You might give them stock options, or exchange stock for intellectual property, but that doesn't imply any particular founder status.

Founder status matters and is an earned and fact-based status: it's the person or people who start the company, and take the risk and responsibility of funding it and keeping the doors open. It comes with a set of risks, obligations, responsibilities, liabilities, and privileges.

The downsides are significant, but the upside can be huge, so you take the good with the bad. Down the road it shows you've had the tenacity, dedication, and commitment to launch something successful, which helps when you go to start your next thing. Investors like to invest in people with a track record.

When you start something with someone else, it's likely different people will follow through with their roles at different levels, and even more likely that a single person will take on more responsibility and risk than the others. That's not always the case, but it's the likelihood. It can be a lot of fun having co-founders, but not all founding is equal.

One person will take the responsibility of raising the money, managing investor relationships, legal, accounting, hiring, managing, etc, and the investors will identify that person as the steward of the investment, while the other co-founders are working on their parts of the business. Usually that person takes the CEO role, but I've seen some companies where the co-founders really share responsibilities evenly. I don't believe that's common though.

One thing you might consider is not having co-founders. Frequently the roles they will play at the beginning can be filled by others with just employee status. The upside is that you don't have any potential for co-founder conflict. The downside is you get less commitment of time and resources by employees than you do co-founders.

Finally, you should have roles, rights, obligations, compensation, ownership, timelines, expectations, values, personal goals, company goals, and responsibilities defined up front. Not that they won't change, but it helps when you avoid assumptions about a range of things up front and get agreement on areas that are likely murky.

Some advice: if you have them, check in with your co-founders regularly. Maintain the relationship by regularly sharing how you feel and perceive things. Don't get frustrated or judgmental; it's likely everyone's working hard. Make sure your goals and values are aligned, and nurture the relationships.

Starting a business is hard work and can be very isolating and emotionally difficult. Even if you have co-founders, it's likely you can't share everything with them. So find other founders and form a support group, or hire an executive coach. I hired a great executive coach/life coach, and it made a huge difference for me, especially when I was making mistakes and feeling lousy about it.

You don't have to go through this stuff alone, and sharing your challenges and feelings with the appropriate audience (not your spouse, and definitely not your employees or investors) can be incredibly helpful. I'm looking forward to the new startup, and am taking my own advice.

Monday, July 13, 2009

Venture Capital Drops Dramatically in Q2

National Venture Capital Association reports a huge drop in new capital placed with venture firms--another good case for bootstrapping and raising from individuals.

Tuesday, July 7, 2009

Raising Capital: Some Things Not to Do

I met with one of my favorite venture capitalists this week for about a half hour just to catch up. I made the mistake of not really having an agenda, so it was a bit all over the place, and there was that moment when you know it's time to wrap it up and move on.

Two things I asked about were his views on third parties raising money for startups--when you hire someone to raise capital for you--and angel conferences, incubator boot camps, and venture financing conferences.

As I've suspected for a long time, he and a lot of VCs don't think very highly of companies that use agents or brokers. It says to them you don't have the drive, ambition, and curiosity to find and pitch VC yourself. And that likely means you don't have the drive, ambition, and curiosity to push you company the way it needs to be pushed to get from seed stage to exit.

What he's saying is something I've believed for a long time: tenacity is more important than opportunity, differentiation, intellect, or innovation.

The USPTO is littered with patents that represent the broken dreams of tens of thousands of inventors who lack the drive or ambition to figure out how to get from invention to market share. So is the Apple App Store. And the Microsoft ISV program. And Techcrunch.

I've had varying degrees of success, but I've always been tenacious, and while I look at CircleDog as a failure (though recoverable), tenacity--not invention or intellect--has served me best.

He made a great point--he's very accessible. Most VC firms are. While they are in the business of saying no, they want the chance to make the judgment.

Passed on Skype? No problem, it happens. Refused to meet with Skype? That's the greater sin. If you fund 10 to 20 deals a year, you're likely turning down about 200. There are about 250 work days a year, which means you have about 1200 opportunities to schedule a meeting with each VC.

I've had a number of companies approach me about raising money. One didn't want to build out their product without funding in place. I already knew my friend's response, but I wanted to see his reaction, so I mentioned the general category to him and the fact that they didn't want to build before funding. He just shook his head.

You gotta have skin in the game. If you haven't invested in your vision, why should VCs? If you haven't convinced friends and family to invest, why should VCs? If you haven't built the application and won over a few customers, why should...you get the idea.

When I start something, I'm all in, perhaps by nature. It's hard for me to believe in something and only go half way. I can't really raise money for someone else's dream if I don't believe in it too--and in them.

But I can and will coach them. I won't write your business plan, but I'll help shape it. Most investors won't read most or even any of your plan, but it's important for you to go through the process of writing the plan because it forces you to envision how you'll build the business. And you might learn something and change your tactics or strategy--which is absolutely fine.

Investors want to invest in smart, ambitious, tenacious entrepreneurs who can recover from failure, learn from their mistakes, refine their approach, and take another crack at it. One of the ways you can show that is by picking up the phone and trying for an appointment.

Send an email. Connect through LinkedIn. Attend conferences where they'll be and introduce yourself. Find someone who knows them.

Just be your cool, kind, ambitions, tenacious self and you'll get the meeting.