Reading time: 1 – 2 minutes

It occurred to me while writing the piece below on the current state of the IPO market that VCs could differentiate themselves by putting in more of their own money into their funds than the traditional 1%. This would lessen the desire to place money into investments solely to gain more management fees (it should be pointed out that most VCs strike it rich from making good investments and not on management fees). It would also align firms more closely with the entrepreneurs they work with. Some VC firms, like MK Capital, are already doing this (MK is the largest investor in their own fund) and it seems to be working great for them. Love to hear your thoughts on this.

Reading time: 2 – 4 minutes

I read a great post today by Matt McCall of Portage Ventures. The post was titled “The Angelitis Blues” and focused on how seed round deal structures can really affect future professional VC funding rounds. Apparently this is becoming a bigger issue in the new “low cost” start-up market. Matt mentions that he and his partners at Portage had to walk away from three deals recently because of the deal pricing discrepancy issue. Essentially what had happened was the entrepreneurs had priced their previous angel rounds too high and did not want to go through a down round.

This is something that I had not thought of when going through my previous “Fixing the VC Model” posts. I had focused a lot on how cheap it was to build companies, the disconnect between the mega VC funds and entrepreneurs needs and how more angel funded companies could be a good thing for entrepreneurs. In reading Matt’s post the hole in my thoughts (one of them at least) was brought to light. I had failed to discuss how angel funded rounds, if not structured properly, could potentially impede a company’s ability to raise money from a professional VC.

I will quote Matt’s example so you can get an idea of the problem:

The company raises the first $500k at a $5M post-$. They grow and need more capital to ramp sales/marketing, so they raise the next $500k at a $10-15M post-$. At this point, the company is probably doing $1-3M in annual sales and growing linearly. The entrepreneur decides it is time to raise a venture round now, and goes to market with a $5M raise at $20M pre-$ valuation ($25M post-$). This is where the disconnect hits.

A company that is growing linearly (say $1-2m going to $3-5m this/next year in revenue) is going to be valued at a $3-7m pre-$ valuation. (I will write about different pricing approaches coming up.) The revenue often does not ramp as quickly as the entrepreneur expects (plans from two years ago had probably shown revenue of $10M vs. the actual $2M). Angels, being less price sensitive, had been willing to invest at the higher valuations. However, when the company needs more capital to scale (and is tired of living off of $500k rounds), it is forced to go to the professional venture community.

Matt provides one possible answer to this dilemma saying that entrepreneurs should use a convertible debt structure for their angel rounds. This will allow the money to convert to the professional VC round when it is raised. The angels may push back on this for various reasons but if they go for it it will ensure the entrepreneur is not stuck in the future. Entrepreneurs should heed this advice and really think past the dollars when considering their initial funding rounds (and all financings for that matter). Thanks for bringing this up Matt. I look forward to some more posts on Angelitis soon!

Reading time: 3 – 5 minutes

Stowe Boyd brought up an interesting notion of Advisory Capitalists (or ACs) last week and it had created a lot of stir with people on both sides of the coin chiming in to flush the idea out. One of the more interesting chime-ins was Fraser Kelton’s. Fraser brings up the idea that VCs could add advisory services to their offering as a happy medium to either VCs or ACs. I liked this idea enough to comment on Frraser’s piece. Here are my comments:

There are a lot of great hands on investors out there that are, in a sense, adding a lot of advising time in with their cash investment. I believe that most of the better VCs are doing this and it is why they are in the positions that they are. Entrepreneurs are getting smarter about capital all the time. They know that they need not only the cash but a partner that will stick with them for the long haul through the good times and the bad. As more and more entrepreneurs figure out that VC isn’t all about the money, more VCs with advisory capacity will appear but the guys that have been doing it all along will still have a good stronghold.

On a side note: It was mentioned that ACs alone would not have the capital to put up once an entrepreneur needed it. This is probably the case (depending on the AC of course) considering that they are only individuals while VCs have a lot of money raised from their Limited Partners to put to work. It was also noted that ACs may not want to part with their vaulable advice for such a small portion of the company. This is especially important considering that ACs would not have the cash to continually participate in subsequent funding rounds leaving their positions to get diluted even further.

Let’s also remember that the VCs are not bad guys. A lot of them are great guys who really want to help companies out. Yes, they are worried about losing investments but it should be noted that a lot of times they are managing money for foundations, non-profits, pension funds and college endowments so the more money they can make the more these institutions will be able to help people (and, of course, the more money they make for themselves as well).

Reading time: 2 – 3 minutes

On to the next post in my “Fixing the VC Model” series that I had promised a week or so ago. Sorry about the delay in posting. The usual excuses apply… Well, I really wanted to get a discussion going about the term of VC funds and how they affect the start-up business. For those who don’t know I will start with a quick background on VC funds and their usual term length.

So, as can be inferred from above, the VC set up is that of a fund. The money for the fund comes from many different places including institutional investors (college endowments, charitable organizations, etc.), high net worth individuals/families and a little bit even comes from the General Partners of the fund themselves. All of the investors in the fund with the exclusion of the General Partners (who are also the VCs) are called Limited Partners. These Limited Partners, or LPs, do not directly make any investment decisions.

The fact that VCs are set up as a fund make things very interesting. Since the investments VCs make are fairly illiquid a time limit for realizing those investments needs to be put in place. The usual time limit is 10 years. The first 3 – 4 years or so being the “investment” and the last 6 – 7 years being the “management” years. You can see how leaving a fund open-ended with illiquid investment could cause problems as far as returning money to investors goes. Theoretically an investment could never be realized and, even if it was eventually realized, the effective internal rate of return would be so low it wouldn’t even matter.

While the term makes sense if you look at things from the investors point of view it does cause problems for entrepreneurs. The main problem is that some entrepreneurs are rushed to exit. I think this is happening less and less now because entrepreneurs can bootstrap a lot of the way before taking VC money but, in the bubble, a lot of companies were rushed to IPO or sale and now continue to flounder or have closed their doors.

The question is: can the VC fund term be changed in any way that will benefit both the entrepreneurs and the VCs? I don’t know that it can because investors still need a way to predictably reclaim their capital. With that said: maybe it doesn’t need to be changed because people may feel that most entrepreneurs are not rushed to exit. Anyhow, I thought I would open the floor for discussion and see what everyone else has to say. Looking forward to some good comments and posts on this!

Reading time: 3 – 4 minutes

I know that I said I was coming out with Fixing the VC Model: Part 3 this week and now you are seeing PFB Revisited. Please consider this Fixing the VC Model: Part IIa. I had to write this post in response to a great post written by Fraser Kelton today. Fraser writes about fixing the VC industry as a whole and includes a section on partial founder buyout (PFB) with a link to Paul Graham’s essay which is where I first saw the idea. Fraser also hits on other topics like customer service, raising less money, etc. Definitely worth a read. The ony piece of the argument which may be a tough sell to VCs is the following:

Focus on a Niche. By focusing on a small niche market, the VC can exploit the long tail of venture investing and enjoy a positive median return. The venture capitalist may have to give up on the ‘hit’, but they should be okay with that. They’re leveraging their expertise in the niche market to make a number of smaller investments, that will yield a positive median return.

A venture capitalist who doesn’t rely on landing a hit to prop up their other investments, and instead aims for a number of smaller returns that yield a positive median return, will be able to compete against entrenched VC firms. By going long tail, and being happy with it, the venture capitalist develops yet another competitive advantage.

Having worked in Venture Capital analytics for a while I know the returns well and I know what LPs (the VC’s investors) pay for. LPs are paying for the homerun fund (homerun compared to a mutual fund). Many times they won’t get it but that is usually what they go into VC funds looking for. To make my point I am going to have to call on two of my best friends from undergrad, alpha and beta.

With the typical 2% management fee and 20% carried interest VCs charge for their services they need to make a large return above the market or a high alpha. They are also taking a lot of risk and have a high beta which drives the desired return even higher. The combination of these leads to expectations of at least a better-than-median return.

While a VC median return is not bad at all (compared to a mutual fund), investors may be upset since they paid for better. However, all of this can be solved if a VC, trying to disrupt the market, takes a lower management fee and/or carried interest with the plan of focusing on a niche for a modest median return. Definitely something to think about. It would mean less money in the short term but could lead to a much better industry in the years to come. Let me give you a glimpse of the future. Possible headline from the 2015: Happier entrepreneurs, better VC returns and more money being made by all! Sounds good to me.

Again, kudos to Fraser for putting together such a comprehensive article. I am glad to see the discussion really picking up. Now, if I only I had some money to start putting PFB (and the other ideas) to work as an angel investor…

Reading time: 2 – 4 minutes

For those of you that have not been following the comments on my first “Fixing the VC Model” piece there has been a great discussion going on. Jeff Clavier commented first and mentioned that partial founder buyout won’t really work with small deals. This is a very good point. For example, if an angel or very early stage VC wants to place $500K into a company then the partial founder buyout (PFB) would not be big enough to align the entrepreneurs interests with the VCs. So, if PFB were to be inserted into a deal, the deal would really have to be larger than $5mm or so but that $5mm could also be spread among a syndicate of investors making it an aggregate deal total.

The next piece of the conversation was lead by Adam. Adam brought up two very good points that VCs would probably consider before using PFB:

1. Control over the founders: Many VCs may believe they’ll lose some control/power once they provide the founders with a $3mm safety net.

2. Company Growth: $3mm may be better off growing the company instead of sitting in the bank.

I will talk about the last point first. First of all, let’s disregard the fact that a company can be overcapitalized killing it from within and say that, in our example, the company could use the $10mm effectively. With that said, I agree that $3mm would probably be put to better use growing the company than sitting in the founders bank account when you look only at the surface. However, when you start to dig deeper one can see that the company could possibly grow more than it would have otherwise with the extra $3mm in the founders bank account because the founders would be more willing to take chances.

On to the point about control. I mentioned to Adam that the VCs would end up with more control relating to their percent ownership in the company which he of course knew. Adam then followed up clarifying that he agreed and actually was referring to the control that VCs have over entrepreneurs. Adam and I both agree that control of the company and not control of the entrepreneurs should be what VCs strive for. I think that there are a lot of VCs out there who do not look to control entrepreneurs but there probably are quite a few that do and would, therefore, oppose PFB. This control issue is something that needs to be looked at if the VC model is ever going to align itself more with entrepreneurs.

I hope that this sum up of the conversation has helped to catch everyone up on the issues with PFB. Please be on the look out for Part 3 of my Fixing the Venture Capital Model series which I will hopefully post sometime this week. In Part 3 I will look at the Venture Capital fund structure to see if it is cauing some of the static between entrepreneurs and VCs. Until then, keep the comments coming. I think this conversation is good for the start-up community and will hopefully be a small step toward effecting the change that I think most of us want to see.

Reading time: 3 – 5 minutes

There has been a lot of talk for a while now about fixing the venture capital model. As it stands now, there are things about the model that do not align the wants and needs of VCs with entrepreneurs. For example, VCs need exits at certain time intervals because their funds only last 10 years (for the most part) and entrepreneurs are sometimes forced to grow too quickly or be acquired too soon because of this. While the structure of VC funds probably isn’t going to change any time soon (after all, the people that invest in VC funds need their money back to pay pensions and do charitable work) the question is: What can be changed? The answer: deal structure.

The way VC deals are structured is something that, with a little creativity, can make the system much better for both parties. There is a fundamental problem between VCs and entrepreneurs. VCs want entrepreneurs to shoot for the stars and to be the next Google. Sure, entrepreneurs want that too. If they didn’t, they wouldn’t be in the game and taking the risks that they are. However, if someone comes along and offers an entrepreneur $25mm for a company he built in his spare time and for little of his own money he is going to take the cash or at least be very tempted to especially if it is his first company. However, that $25mm offer looks paltry to a VC who, lets say, put $7mm into the deal at a $22mm post money valuation (and sees the company eventually being worth $500mm). The return on investment for the VC does not line up with the return on investment for the entrepreneur.

Partial founder buyout can change this dynamic by giving the entrepreneur a little liquidity early on. Let’s say that, in the above scenario, the VC actually put $10mm into the deal but $3mm was actually paid in cash to the entrepreneur and $7mm went into the company. Now, the entrepreneur has $3mm in the bank. This is not enough to make him too comfortable but it is enough to reduce, if not eliminate, his urge to sell out quickly for $25mm. Now, the entrepreneur is more likely to take the plunge with the VC and try to become the next Google knowing that his house and his childrens’ college educations are taken care of.

If this type of situation was in practice today I think we would have already seen its effects. Let’s take Flickr for example. The founders of Flickr built the company on a shoe sting in their spare time. Network effects began taking hold and before they knew it they had an incredible company on their hands. At that point the founders needed to make a decision: do they take capital from a VC and scale the business like crazy possibly gaining nothing or do they take the “sure thing” offer on the table from Yahoo! and cash out early possibly leaving money on the table but also taking in enough money to live comfortably forever? In this case the founders took the Yahoo! deal and probably regret it today but can you blame them? They were looking at a lot of guaranteed cash or getting their ownership diluted possibly for $0 return. The same situation could be applied to a number of other companies including del.icio.us.

With partial founder buyout a lot of entrepreneurs would be still out there building their companies and VCs would be left with more quality investments. Everybody wins (except maybe Yahoo! and Google since they wouldn’t be seeing any more inexpensive acquisitions). To make things clear, this is not an original idea. I have seen others write about it and have been surprised that there hasn’t been much take up. I thought I would write about it to get it back into the discussion so please tell your friends (especially if they are VCs and entrepreneurs) about this blog entry so they can add to the discussion in the comments and on their own blogs. This is something that needs to be looked at because it could change the start-up game forever and in a positive way for all involved parties.