We received so much positive feedback from our This Week in Venture Capital show walking through valuation calculations & term sheets that we decided to do a Q&A show this week to address topics that entrepreneurs want to learn about.  We will continue to do more of this.

If you want to watch the show click the image above or this link, but if you want a quick read – here’s a summary (oh, and if you’re wondering – Jon Stewart copied me – not the other way around):

1. @tevye2009, Q: “can you briefly explain why it’s best to get a small valuation when getting investment.” A: It’s not best.  The best thing to get is a “right sized” valuation.  People assume that I’m biased because I’m a VC and think you should always get the highest valuation possible.  This is wrong.

I explain in the video what happened in my first company (e.g. on the entrepreneur side of the table) when I raised at too high of a price.  I eventually needed more money.  The A round was done in February 2000 (end of the bull market) and my B round was done in April 2001 (bear market).  As a result I had to do a down round.  Down rounds are psychologically really difficult on companies and can make it harder to do later rounds.

So don’t raise money at a cheap price, but don’t get too far ahead of yourself either.  Pricing high also takes exit options off the table.  In the video I also covered why you shouldn’t raise too much money too early in your company’s existence.  We also discussed how to deal with pricing in angel rounds and a strategy I advocated in my “social proof” blog post, which is to price your initial angel round really low and get in the best possible angels as a way to get momentum in the company.   This question runs from about minute 2 – minute 8.

2. Mike Stern (wasn’t sure which one so leave a comment if it’s you): Q: “is it possible to sell your startup without venture investment if the company has big traction and a large user base?” A: Yes.  In fact, far better if you haven’t raised venture capital.  People buy companies for 3 primary reasons: 1) they want the management team / talent 2) they want the technology or 3) they want the market traction (revenue, customer base, profits, etc).  People also buy for defensive reasons or ego but that’s a different story.  But the key is that if you want to sell your company you need to have active relationships with potential future buyers.  We discussed that at length in this TWiVC with Michael Montgomery.  But to the question – it is much EASIER to sell your company if you’ve never taken venture capital.  Angels have a much lower threshold for returns than do VCs.  This is minutes 8-11.

3. Mark Jeffrey - Q: “Is it more traditional to do your ESOP (employee stock option plan) before or after your angel or Series A funding?” I got on my soap box on this topic.  I talked about the need to have a restricted stock plan for your earliest employees.  This has HUGE tax benefits to those that join early.  See this chart to show you just how much – around 2x the taxes.  The downside is that people need to buy their stock.  But if you do this early (pre VC) then the price points are pretty low.  I talked also about 409a valuations and why common stock purchases cost less than preferred stock purchases.

But most importantly I lectured founders that you can’t avoid the admin of setting up your ESOP.  Do it early.  I’ve heard every excuse in the book and you’d be surprised how many people put this off.  You’re not screwing me – you’re screwing your fellow employees.  The longer you wait the higher the price they’ll have to pay and the less time the clock will be ticking on long-term capital gains tax.  Bad behavior but prevalent.  If you’re working at a startup and the founding team is promising that they’ll “get around to creating an employee stock option plan” soon – demand it now.  Minutes 11-16 in the video.

<< we then discussed the need to do trademarks on your company and your key brand names.  We told the horror story of the company that originally owned the URL groupon.com and lost it due to not having a trademark.  we thanked our sponsor, LegalZoom, for providing trademark services cheaply >>

4. Q: “If you have a term sheet on the table how should you leverage with other VCs?” A: You need to SUBTLY let other VC’s your speaking with know that you have a term sheet.  The best way is if they hear from third parties but if you can’t manage this it’s OK to tell them directly.  Just say, “listen, I don’t want to pressure you but I wanted to let you know that we received a term sheet that we’re considering.  We think we can take a couple of weeks but in case you were interested I wanted to be sure that you didn’t find this out at the last minute.”  I discussed the need to be careful of Gym Salesman VCs and “exploding” term sheets.  I also gave some tips on how to politely but successful stall the VC pressure to sign your term sheet quickly.  I think this section is so important that anybody raising VC should at least view this section.  There’s some stuff here that I even prefer not to put into writing.  Minutes 18.30 – 26.30.

5: Q: “What’s the best way to get a VC’s attention in an email” – I’ve written about this topic so more in depth is here on How to Access a VC as well as I Emailed a VC and Never Heard Back – What Now? First advice – don’t respond to a VC website that says “submit your business plan here” – if it’s read at all it will be read by an intern and likely be filtered before it reaches a decision maker.  Second – don’t send unsolicited emails to VCs.  I get them all the time and I try to respond to as many of them as I possibly can.  But one of the things that VCs look for is how you get access to us.  In the era of social networking if you can’t figure out how to get intro’d to me you probably aren’t cut out to be an entrepreneur.  Tough, but true.  So in the video I talked about the “stack rank” of intros: portfolio companies, entrepreneurs, lawyers as the main ones and other investors as the secondary way.  Never cold.  Never.  And I talked a lot about persistence in the video.  Starts at minute 41 – a very worthwhile piece to listen to.

6: @marklanday Q: “Do you make personal angel investments and if so what are your criteria?” I talked about the rules GRP has set up for allowing angel investments (has to be in an area we don’t typically invest, in a company that doesn’t have the ambition to build a big business or a company that GRP has turned down.  We don’t want to compete with our LPs.  I have a link on my blog to the angel deals I’ve done, which is here.  I also spent a bit of time talking about why I think angel investing is a mug’s game.  I typically do it just to support entrepreneurs I like, to learn about a space (you learn from the inside not by reading TechCrunch) and to build relationships with other investors.  To make money as an angel I believe you need to do at least 20 deals and have deep enough pockets to put wood behind 3-4 of them that succeed more than others.  If you want to understand why – check out the video starting at minute 49 or so.

7: Q: “Should I take an investment from a family member?” A: No.  Not if you don’t have to.  If you are thinking about angel investors please read this piece I did on Angel Funding Advice. I also did a piece on how to think about pricing on angel deals.  But quicker answer – here’s your stack rank: 1) knowledgeable entrepreneurs who have made a lot of money, are prolific angels, know other angels & VCs and know your industry / space 2) same as 1 but don’t know your space 3) know your space but don’t have hugely deep contacts.  But they do have money and they are realistic about angel investing. 4) business people in general who understand angel investing 5) doctors & dentists (metaphorically) who are realistic about angel investing.  Most are not. 6) friends & family.  I  know everybody tells you to start with F&F but here’s the thing.  Most likely your venture will fail (most do!) so why burn out your family & friends unless you have to.  Obviously if they are very wealthy or they fit categories 1-4 above I’d have a carve out.  Anyway, it cover this at length in the video around minute 57.

ALSO!

In the video we did a lengthy discussion on “the return of enterprise software” talking about companies: Atlassian, Jive Software, KickApps, Yammer and SquareSpace.  Most importantly we talked about my good friends at Okta who were financed by Andreesen Horowitz.  They have a great user proposition and a phenomenal team.  Check ‘em out!  I talk about the company in the video.  I think this section started around minute 27 but not 100% sure.

We covered the week’s M&A deals: Playdom and Kongregate and why Disney and GameStop made the acquisitions.

Let me know if you liked the format of the show.  Do more?  Do less?  Are the write ups worth doing or not? (they take time!! but if people like them I’ll do them).

Social Proof in Action …

Yesterday I wrote about the benefits of using social proof and authority in raising venture capital.  If you didn’t read that yet it might be worth having a quick skim as a primer.

Social proof is defined as “looking for others to guide our decisions” and is also one of the most important techniques in acquiring customers in your company.  Many of you have read or at least know the primary thesis of “Crossing the Chasm” the seminal book on marketing your products to mainstream consumers by Geoffrey Moore.  It influenced a generation of tech marketers.

The book popularized the technology adoption lifecycle curve that originally came out of Iowa State University shown below.  We all intuitively know this curve now but we don’t all market effectively to it.  Chris Dixon alluded heavily to it in his brilliant post on “Techies and Normals.”  People who are “innovators” or “early adopters” like to be at the cutting edge.  We like to use new product and gain benefits before our peers.  We are evangelists.  We check-in when we go to restaurants when everybody else is wondering when we’re going to put away our F***ing iPhones or Blackberries.  We have to be first (this image is worth a click, I promise).

In short, innovators and early adopters have faith that there will be benefits to using products that are unproven and even if they don’t they enjoy the process of using new stuff.  This applies to business users as much as to consumers.  Sometimes these markets never appeal to “normals” (Chris Dixon’s definition) and other times it needs to be more effectively marketed to normals.

So the early part of a technology company is about finding your hard core group of early adopters and making them passionate about your products.  You need to give them “back stage” passes to your company.  You need to give them advance notice of your product development or better yet let them help influence your direction.  Sure, they need a little social proof.  If they hear that Robert Scoble, Michael Arrington or Jason Calacanis loves your product they’re more likely to give it a try.

This is what drove early adoption at Twitter, FourSquare, Quora and is now driving people obsessively at FlipBoard.  I must be an early adopter rather than an innovator because I DO NOT have my knickers in a twist to get on FlipBoard.  It looks cool, but I can wait.

But here’s the thing – the early & late majority will never come without social proof.  These are the people who want to see ROI studies (business), read NY Times reviews by David Pogue or WSJ reviews by Walt Mossberg (consumer).  And the key to understand how to market to these people is to understand the point made in the book “Yes” by Robert Cialdini.  Regarding “social proof” he says,

“Earlier we described the importance of testimonials in trying to sway others’ opinions in your direction.  The results of this experiment [the one on hotels listed in my previous post] suggest that the more similar the person giving the testimonial is to the new target audience, the more persuasive the message becomes … You should begin not with the testimonial you’re most proud of, but with the one whose circumstances are most comparable to your audiences.”

This is where heroes come in.  Heroes are those every day users of your product who are not overly senior in ranks but are in charge of implementing your solution within their company.  If they’re consumers they’re just everyday people like you and me.

Salesforce.come is brilliant at marketing heroes and I think Marc learned it in turn from Oracle.  We would take every day users from our customer base and make them heroes.  Here are some examples of heroes in action:

• A testimonial / quote from a hero on the banner on the home page of your website with their image and a link to a case study on how they used the product
• Speaking at a “city tour” in which Salesforce.com sales reps and executive management were present.  Heroes told our success stories, not us.
• Leading breakout sessions at our annual conference – DreamForce
• Speaking to industry analysts at Gartner Group, Aberdeen, IDC, Yankee Group, etc.
• Taking reference calls from prospects considering using our products

Marketing heroes is brilliant and you should find ways to implement in your organization.  On the one hand the early & late majority are more apt to listen to the benefits of your products from their peers through social proof than from any corporate bumpf you can produce to convince them of the benefits of your product.

On the other hand, what better way to build strong relationships with your company’s strongest supporters.  How often do every day employees get to appear on the home page of a major website, speak at a conference or get to talk with market analysts?  You’re elevating them in ways their own organizations probably do not.  And in turn you get not only strong endorsements but even more loyal future supporters.

Think about this – what is more powerful – a VC who tells you how great he/she is or when you read your peers reviews on The Funded?

And heroes work on the consumer side, too.  Ever notice all those iPad billboards are just ordinary users like you and me sitting on a couch using a product that they know you’re going to love?  OK, I know Apples has an unfair advantage – but the emotion their going after is social proof.  People like you use this product.  It’s easy.  It’s what they do when their sitting on their couch watching TV.  Everybody is doing it.

How are you going to cultivate and gain the support of your company’s heroes?  How will you work with your heroes to gain more early adopters or to market the early majority more effectively?  We already know from Cialdini that this is even more important than your putting a link to a press articles yet how much time do you spend trying to market these to everybody?

I recently read a book I’d highly recommend to every reader of this blog called “Yes, 50 Scientifically Proven Ways to be Persuasive” by Robert B. Cialdini who is also author of a very well received book called “Influence” (which I plan to read).

“Yes” was given to me by one of my favorite angel investor / seed VC’s to work with – John Greathouse of Rincon Venture Partners and author of the blog InfoChachkie that you should check out because it is filled with great info from a guy who has been a very successful operator.  Rincon is part of the new breed of Seed Stage VCs and with the leadership of Jim Andelman has charted out the most authentic early-stage investment strategy in Southern California.  Any SoCal entrepreneur raising early-stage money should put Rincon on their short list.

John gave me the book after I spoke at his entrepreneurship class at UCSB.  I was excited to read it because Robert Cialdini had been a speaker at Google when my wife worked there and she told me that many members of the senior management team at Google had been raving about his work.  I decided not to be bothered by the cheesy title and to read it anyhow.  You should, too. (no, I don’t take affiliate commissions!)

The book is a layman’s guide to understanding how we as humans make decisions and is underpinned by data-oriented studies to prove his claims.  He lists 6 principles of social influence that I’d like to cover in a series of posts: authority, social proof, reciprocity, commitment / consistency, scarcity and liking.

I’ve been meaning to write about this for a while and was going to use AngelList by Nivi & Naval as the basis for my example and the perfect prompt came yesterday when I read Fred Wilson’s blog post on AngelList.

Social proof is defined as “looking for others to guide our decisions” and it can be both explicit and implicit.  We all want to think that we’re unique and original thinkers but we’re far more guided by others than we think.

In the book he talks about movement over the past decade to get us to reuse our towels more when we stay at hotels.  It is clearly a ploy by hotels to cut costs but it also benefits the environment.  No cookies for guessing which reason they use to market to us.  It turns out that more than 50% of us reuse towels at least once during our stay at a hotel because it appeals to our “commitment / consistency” value trait to want to be respectful of the environment.

But Cialdini knew they could do better.  He ran an experiment in a hotel in which he polled people on whether or not they reused towels during their stay and as expected just over 50% did.  He then put signs in some of the hotel rooms that said, “the majority of guests at this hotel reuse their towels at least once during their stay.”  26% more people reused their towels at least once during their stay when they had this sign versus the standard sign.  Classic social proof in decision making.

He went one step further.  He then put a sign saying, “people who stayed in this exact room reused their towels at least once during their stay.”  This increased the number of re-users to 33% above the control group.  We want to do what we believe others like us are doing.

While I feel that I tend to have a strong POV on many things I’ve always been aware of the social proof impact on my decisions.

The very first thing I do when deciding which movie I want to see next is check its rating on RottenTomatoes and if the film is North of 80% then it’s a “no brainer” for me to go and see.  If it’s below 50% I will almost never go and see it.  I suppose you could call this “The Wisdom of the Crowds” (another great book).  If you haven’t read it you should definitely buy it – other people just like you did

When I want to go to restaurants I check out Zagat and Yelp.  Before booking a hotel I always check out Trip Advisor and read reviews.  This is all explicit decision making.

So how does this apply to you?

First, no matter what anybody tells you (people don’t want to believe that we’re influenced by the crowd), social proof is hugely important in fund raising. Every angel, seed investor or VC  is influenced by who else is talking with you, who else is investing in you and they (we) are all influenced by who introduced us to you.

If you want to hear an entrepreneur talk about this topic listen to Farb Nivi tell the story of how he got Rob Lord to invest in Grockit and how that led to Reid Hoffman and in turn Benchmark Capital, Integral and Atlas – more than $15 million in total.  He covers this is the first 15 minutes or so of the video and he’s awesome to listen to (more than 25,000 people have listend to this video so far – mostly entrepreneurs ;-))

Nowhere is social proof more prevalent than in angel investing.  As Fred points out in his post:

“Angels love to share deals with each other. It is how angel rounds come together.”

Or put another way – angels look for social proof from other angels.  It’s hard for angels to assess whether or not to invest because they often have day jobs and can’t commit to the kind of due diligence that most VCs go through.  Angels are writing smaller checks so they typically don’t want the overhead of complex analysis in order to make their decision.

So what you really need to get an angel round together are your “anchor tenants.”  These are the people who make the early commitment to you to fund your round before having any social proof.  You should seek to get people who are respected by others in your field and who will therefore make it easier to raise the rest of your angel round.

In the video I linked to above Farb talks about how he got Rob Lord on board at Grockit.  He first worked hard to get him to be an advisor to the company.  From there Rob decided to make a small investment.  Often people don’t like to be the only person writing a check so they’ll try to find safety in numbers by investing other angels to look at the the deal and “see what they think.”  That’s social proof, too.

I was once thinking about writing a blog post called “Is Reid Hoffman the Kevin Bacon of Silicon Valley” because it seemed that every angel / seed investor I knew looking at deals was shopping their deal to Reid and everybody wanted Reid’s opinion before committing.  Maybe a more apt title would have been “Is Reid Hoffman the Yoda of Silicon Valley?”  When I met recently with Keith Rabois of Slide he called Reid, “the smartest thinker in consumer Internet in Silicon Valley.”  Chris Dixon called Keith (paraphrasing), “the new Reid Hoffman now that Reid works for Greylock.”  Social proof meets social proof meets social proof.

But what is at play with Reid is another principle called “authority.”  Again, even though VCs are populated by Stanford & Harvard MBAs who all seemed to graduate near the tops of their classes – we’re all in search of authorities we trust to help guide our decisions.  Because I built two SaaS companies and sold my second one to Salesforce.com (where I then took on the role of VP Products) I am often asked to look at SaaS and/or sales-oriented deals for others.

Whenever I see something in financial services I always ask my partner Brian McLoughlin who has spent more than a decade looking at Fin Services deals or I might send it through to Mark Goines who is a phenomenal angel investor (invested and on the board of Mint.com) and was previous SVP at Intuit.  Anything requiring lead generation and/or customer acquisition I call Matt Coffin.  We all want authorities who are smarter on specific topics than we are.

So you need to find anchor tenants who have authority in your field and who are respected by other angel investors in order to maximize the benefits of social proof.

Another successful strategy (in addition to bringing on people as advisors) that I’ve often recommended to people who don’t have a track record is to carve out a very small amount of seed investment (say $50,000) and offer 5 people to invest at $10,000 each at a $500,000 post-money valuation (which means you give up 10% of your company for very little money.  The key to this strategy is getting 5 people who form the social proof to help you get a bigger angel round done at a higher valuation by tons of industry insiders and thus offering the social proof you need attract great employees and ultimately venture capital investors.

Obviously I’m assuming that you have a great product and/or strategy.  Having the right angels in a round that is cheap won’t help you succeed if your product or strategy sucks.  But assuming those are sound, strangely I have found over the years that even the wealthiest people want to feel like “they got a deal.”  So if that is all it takes then it is a rounding error to your future success.  I’d far rather dilute 10% early and get some investor traction than to wither for another 3-6 months trying to get my seed round together.

And to echo what Fred Wilson said in his post about AngelList – it is social proof on steroids.  You often have to have your anchor tenants before Nivi will send around your deal.  The emails we all get on the AngelList get say something like, “New gaming platform invested in by Dave McClure, Chris Yeh and Jeff Clavier.  They’ve raised $200k and are looking for $500k in total.”

As an investor it’s hard to not be influenced by an email like that where you respect the early investors and at least want to read about the company.  So even if you’re not getting funded by everybody you’re instantly on the who’s who radar of the investment world.  In a way, it’s even more precision for the investment world that TechCrunch.

To finish with a quote from Fred,

“I am on AngelList. I see all the deals come together. I don’t personally invest in angel deals in the web/tech space because of potential conflict with USV down the road. But even so, I find it immensely useful to see what companies are getting traction in the angel market. It’s part of my radar/early warning system.”

Authority + Social Proof + Traction in getting rounds done quickly = perception that this is a company that should be on my radar screen / I should pay attention to.  So what are you waiting for?  Go get your anchors.

UPDATE: Just because I believe in the power of social proof does not mean that I advocate being a lemming when one makes an investment.  I have always been and remain anti conventional wisdom.  In this post I’m merely pointing out that people look for references from authority and knowing that people are influenced by social proof should help people looking to raise money.  As someone investing – caveat emptor.

In my next post I’ll talk about using social proof in getting customer traction.

Back in 1999 when I first raised venture capital I had zero knowledge of what a fair term sheet looked like or how to value my company.  Due to competitive markets we ended up with a pretty good term sheet until we needed to raise money in April 2001 and then we got completely screwed.  It was accept the terms or go into bankruptcy so we took the money.  Those were the dog days of entrepreneurship.

But the truth is that I didn’t really understand just how screwed I was until years later when I finally understood every term in a term sheet and more importantly I understood how each term could actually be used to screw me.  Things like “participating preferred stock” in legalese unsurprisingly never actually call out, “hey, this is the participating preferred language.”  We got a 3x participating liquidation preference with interest (not participating with a 3x cap, but 3x participating.  Ugh. I explain the difference later in the post or you can click through on this link above for an explanation).

Back then VentureHacks didn’t exist.  Brad Feld hadn’t written his seminal “term sheet series” and The Funded hadn’t yet been created.  And for some strange reason entrepreneurs didn’t share this information.  Other founders, “as a privately held company we don’t disclose our valuation.”  Me, “dude, I’m not a journalist.  I just want to figure out what a fair valuation is.”  I figured all the VC’s talked so we should. Duh.

I don’t feel that as a VC sneaking in nefarious terms into a term sheet that the entrepreneur doesn’t understand is a good way to build a long-term relationship nor to build a long-term reputation but this does happen and more frequently than we all would like.  I’ve started from day one trying to build total transparency into my process with entrepreneurs.

This starts with understanding how VCs and entrepreneurs often see valuation differently.  And no prizes for guessing which side of the table really understands the right answer.  I’m not sure I really even need to write this at length because Nivi absolutely nailed the topic in his article “The Option Pool Shuffle.”

When I went to raise money in 2006 I thought I knew every term in a term sheet but somehow I still got a bit duped by the option pool shuffle.  I had several term sheets and one of the leading term sheets had an option pool of 40% in it.  I couldn’t understand why they wanted so many options until a friend pointed out that this just lowered their “true” pre-money valuation (they also asked for some sharp elbowed terms in the deal).

I turned them down.  They were nonplussed.  They couldn’t understand how I could turn them down when they considered themselves the leader in my field and they had worked so hard to get the deal.  I told them that True Ventures had stuck to their brand name and submitted a totally clean term sheet.  No gotchas.  No option pool shuffle.  No hidden terms.  So they agreed to match True’s term sheet.  I thought to myself, “OK, they were willing to F me when they thought I had no idea what I was talking about . Now that I do they’re willing to accommodate?  Gee, if they treat me like this in good times I wonder how they’d treat me in bad times!”

So to make sure it never happens to you, as a loyal reader of this blog and hopefully an occasional watcher of This Week in Venture Capital, I recorded a video session with my colleague Kelly Hwang on how VCs calculate valuations and he’s created a cap table spreadsheet you can download from DocStoc to plug in all of the terms and you can watch the video here and/or read the text summary below.

How VC’s Calculate Valuation: We walked through a standard deal where you raise $1 million at a $3 million pre-money valuation leading to a $4 million post money valuation.  The math works out that the investor owns 25% of the company post deal ($1 million invested / $4 million valuation) and assuming 1 million shares, each share would be valued at $3 / share ($3,000,000 pre-money / 1 million shares = $3 / share).  Investors own 25%, the founders own 75%.  NOTE: In the video I talked about how VC’s and entrepreneurs decide the total number of shares at the first major funding round and why it’s often a high number.

But this example above is all entrepreneur math, not the VC’s.  The VC assumes you’ll have an option pool.  That’s normal.  You’ll need to hire and retain talen to grow your company.  Those options need to come from somewhere.  The more senior members you have (say you already have a CEO, CTO, VP marketing, VP Biz Dev, VP Products) then the less options you’ll need and vice versa.  Industry standard post your first round of funding will be 15-20%.  I say “post” funding because you’ll need more than this amount pre-funding to get to this number after funding.  We walk through this in the video.

So taking the same fund raising round and assuming that the VC wants the options including before he or she funds (and before is totally standard) then the math works like this: Assuming a 15% option pool post funding then you need a 20% option pool pre funding (because the pool gets diluted by 25% also when the VC invests their money).  So your 100% of the company is down to 80% even before VC funding. Normal.

The VC’s $1 million still buys them 25% of your company – it’s you who has diluted to 60% ownership rather than 75%.  The price / share is actually $2.40 (not $3.00), which is $3,000,000 pre-money / 1,250,000 shares (because you had to create the 250,000 share options).   Thus the “true” pre-money is only $2.4 million (and not $3 million) because $2.40 per share * 1 million pre-money outstanding shards = $2.4 million.

Note that the term sheet you get will still say, “Pre-Money = $3 million” and there won’t be anywhere in the term sheet that says “true Pre-Money” or “effective Pre-Money” – that’s for you to calculate.  So let’s start calling the term sheet listed pre-money valuation as the “nominal” pre-money valuation.  Luckily you all now have the spreadsheet to download that will calculate both for you.

Term Sheet Overview:

The second most important economic term in the term sheet other than price is “liquidation preference.” This states how the proceeds from a sale or dissolution of the company will be distributed.  Investors will always want to get their money out of the company before founders, which in the case where the company is sold for a low price is fair.  You almost certainly will have liquidation preferences if you raise VC so don’t worry about having them.

But not all liquidation preferences are equal – we discuss all this in the video – some can have a “multiple” on top of them such as a 2x liquidation preference, which means that investors get 2x their money before founders get anything.  In an early round of investment where there is not an extremely high price relative to normal valuations this is anything but benign.

More likely what you’ll see if you have an aggressive term sheet is “participating preferred” stock.  This means that investors get their money back AND they get to share in the proceeds.  If you’ve raised $6 million in total and still own 40% of the company and sell for $10 million (not a great outcome but it happens) then with participating preferred investors would take $6 million off the top and then 60% of the remaining $4 million so the founder’s take would be $1.6 million (.4 * $4 million) and not $4 million. Note that it might be even less than $1.6m because liquidation preferences often have interest calculated on top of them.

VC’s in early rounds will argue that “participation” is simply downside protection and if you sell for a lower price they should get more of the proceeds.  While true, the problem I have is that any terms you have in your early stages will certainly be asked for by future investors in your later funding rounds so all of these terms pile up when you’ve been through 3-4 rounds of funding over a 5 year time frame.  And by the time most companies get to an exit (which despite what you read on TechCrunch about all the high-profile early exits the most realistic case is still 8-10 years) often the founders own very little of the economic upside.  This is a shame.

Privately some early-stage VC’s talk about participation helping them to “juice their returns” on smaller exits.  This is silly talk.  I don’t imagine any VC seriously makes money by having tons of small to mid-sized outcomes and therefore “juicing” to me is delusional. I think VCs make money by investing in 20-25 deals and finding 2-3 outliers that drive extra-ordinary returns.  And those are often done by the best and smartest founders who have enough knowledge to know which VCs are juicers and which aren’t.  You reap what you sow.

I also won’t say there is never a time for “participating preferred” but it tends to be in later-stage rounds and particularly in the case where the founders are getting an exceedingly high valuation relative to the norm.  In those cases there are all sorts of mathematical reasons why participation might make sense.  These are edge cases.

But for founders stuck in this negotiation about participation or not with VCs the most standard compromise is “participation with a cap” which is usually set at 2-3x their investment.  This means that participation truly only applies in downside scenarios and once your exit outcome is above a certain price investors would still be better off converting to common stock and not taking their preference.  I prefer to see no participation but this is a good compromise if you can’t get a straight 1x liquidation preference.

After valuation in the video we went through Liquidation Preferences, Board Seats, Protective Provision, Voting Rights, Drag Along Rights, Redemption, Anti-Dilution and a few other key terms.  We spend a lot of time on them in the video but frankly we could have done a 3-hour session.  If I get demand from people after this video to do a deeper dive on term sheets we will.  Heck, maybe we’ll even invite a lawyer on to do it with us!

Yesterday I wrote about the importance of choosing happiness.  Today I want to write about a related topic: not taking the little things in life for granted.  I promise not to turn this blog into a personal self-help blog!  But today is a special day and I’m thinking about this topic so please humor me just one more time.  More later in the post.

When I was in my early 20′s I was fortunate enough to live in a small house in Manhattan Beach, CA with a beautiful ocean view.  Having been born in Philly and having been raised in landlocked Sacramento, CA it was truly an amazing thing to literally hear the ocean waves crash every night from my bedroom as I went to sleep and to see the ocean view every morning as I got ready for work.

For weeks or months I gazed at the ocean at every opportunity I could.  ”Pinch me – is this my life?”  But slowly, strangely and without notice I stopped looking quite as much.  I’d love to say that I always appreciated the majesty of the ocean and the sunsets every night.  I didn’t.  Eventually the ocean view just became life and life was filled with work, stress, bills, cooking dinner, watching football, suffering hangovers, talking on the phone, whatever.  The ocean had just become a picture on the wall that I occasionally glanced at.  I wish I could say otherwise.

Through hard work and persistence I got transferred to Europe.  It’s a fun story how I got there but I’ll save that for another day.  By the summer of 1995 I was living and working in Rome, Italy.  To this date the six months that I worked in Rome goes down as one of my favorite experiences in life.  Il Bel Far Niente!  Every day I took a Roman taxi to work (and still lived to tell about it!) and every day we passed by the Monument of Vittorio Emanuelle II – so beautiful.  (although the Romans don’t all think so – they call it “The Wedding Cake” or “The False Teeth.”)  Me?  Sheer beauty.  We also passed by the Colosseum.  For weeks I gazed out every time and sucked in the experience.  But eventually I started zoning out on the drive in – just another day in the office.  And then I started reading the International Herald Tribune lest I miss my daily dose of international politics.

I think you see where this thing is heading.

In 1996 I worked (then later lived for 8 years) in London and passed daily through Trafalgar Square.  It’s beauty undeniable but as ephemeral as the others.

In 1997/98 I spent months in Barcelona.  I was initially in an aparthotel on La Ramblas and later in a stunning villa near Park Güell.  Every day I walked passed Gaudi buildings on my way in the morning and again in the evening.  For weeks, maybe months, I looked up every day.  If you’ve never seen Casa Batllo (It’s the image at the top of the post) I’m telling you there’s nothing like in the world.  It’s really that awe inspiring.  As are Sagrada Familia, Casa Mila, Park Güell and his many other creations.  (If you don’t know Gaudi or Barcelona enjoy clicking all those links. Really, it’s worth the 10 minute diversion).  Predictably over time I started more noticing the tapas restaurants below these buildings of splendor as I craved a morning fix of coffee and food to stave off my hangover.  Otto Zutz never let out early in Barcelona.  So Gaudi became commonplace.

And this is how I lived the first 32 years of my life until I met my wife.  And thus the reason for today’s blog.  It’s my eighth wedding anniversary today (don’t worry, she’s as the spa having a massage while I’m typing this!).  I was married July 20, 2002 when I was 34 years old.  I had the privilege of experiencing so many things in life by that point that by 34 I truly knew what I wanted.  And it was Tania.  For life.

I knew I was in love when we first took the Eurostar together to Paris for a long weekend.  We stayed in the Hotel Vernet in Paris near the Arc de Triomphe.  It was a majestic hotel in the city of lights and we strolled for hours and hours sucking in every building facade, every cafe and every bistro.  We sipped Cafe Creme in the mornings and Bordeaux in the afternoons.  We talked for hours.  We sang show tunes as we strolled through the Jardin de Tuileries.  Cheesy, I know.  But it was a shared common experience from childhood and to this day we still do it.  What can I say, I’m Jewish – show tunes are in my blood!

But long before I asked Tania to marry me I knew what I wanted out of marriage.  I came from a generation of people whose parents had big families and started at young ages (my mom was 23 when she had my older brother and had 4 kids by 30).  And many parents in that generation became de facto families rather than husbands and wives.  So I guess it was no big surprise that when the kids flew the coop many parents found themselves alone with partners that they no longer saw as their romantic “better halves”  and got divorced.  My parents included.  I’m sure they’d tell their story differently but this is my version.  And that of many of my friends and their now divorced parents.

I think that many of the people from my parents generation eventually took their marriages for granted.  I swore never to.  I wanted something different in life.

I only asked my wife for one big concession before we were married.  I wanted her to agree that we would be friends and lovers as well as parents and a family.  I asked her to commit to doing one night every week as “date night” away from the kids.  She agreed and we’ve stuck with it since Jacob was 12 weeks old.  7 years later we go out almost every week as a couple – sometimes with friends, sometimes alone.

It’s not for everybody.  Some of my closest friends refused to go out without their kids when they were young.  They wanted to be families 24/7.  One even later admitted to me that they felt kind of sorry for us that we didn’t see our family this way.  He admitted this to me in a bar after his wife left him by announcing that “she didn’t love him anymore.”  She didn’t even make a real effort at reconciliation.  He (and I) were devastated.  They have two lovely kids.  I don’t think that the lack of date nights was the cause but I do think that there was a certain amount of taking each other and their marriage for granted.

I don’t take my wife for granted at all.  Whenever I come home from a day of 8 meetings plus an evening speaking event I always instantly feel serene and I always thank her for that.  I am fortunate to come home to my understanding wife who knows what it is that modern workers go through.  And I know that I’m not the easiest person in the world: I have strong opinions, I’m self righteous, I’m stubborn and I’m less organized at home than I could be.  I’m grateful that I have a true friend & partner who loves me for who I am rather than for my potential.  And I’m grateful to have a wife who doesn’t bust my chops when I start writing blog posts as 10.30pm in the evening as I so often do.  She knows writing makes me happy and she is unbelievably supportive (except when I come to bed at 2:30am )

And that’s why 8 years into this marriage and 10 years since dating I can say that I’m as happy with my wife as when we met.  I now have a family with two kids, whom I adore.  But our life is a strain like for any family.  They don’t want to go to bed and night, they refuse to eat vegetables, they have everything in life and are not as grateful as you might expect.  So life becomes a routine.  But not one that I take for granted.

Sleeping faces are my modern day ocean views and I look EVERY night.  I’m conscious that “the days are long but the years are short.”

I love you, Tania.  And I don’t take our happiness or our relationship for granted.

[and to readers I promise not to make this an annual post or to be this mushy on a regular basis.  Please just think about what you have in life for which you are grateful and find ways to make sure you don't take it / them for granted]

Startups are hard.  When you read the press you only read the glamorous bits.  You read about Mark Zuckerberg or the guys at FourSquare, Twitter or Zynga.  But that’s a bit like reading about your state lottery winner and feeling bummed out because you haven’t won despite years of trying.  The reality is that most of you will never hit it BIG yet you’ll lead fulfilled and productive lives.  Whether you choose to be happy or not is up to you.  Will you choose the dopeness or the wackness? (if you don’t have the reference and want it you can click the image above)

Life is hard.  It’s hard for everybody.  We all imagine that somebody else has it figured out yet when you meet the people who you think actually do have it all you find out that life is hard for everybody.

I point that out because one of my favorite quotes in the world (and one I often repeat) is that “life is 10% how you make it and 90% how you take it.”  It’s not a recommendation that you don’t have to put in effort to make your life better.  It’s an acknowledgement that whatever the outcomes in your life you can choose to be happy or choose to be miserable.**

If you want some tips on small changes to make your daily routine more happy check out this post, “Ten Tips for Being Happier.”

I have a friend who I estimate is worth about $500 million.  I have another friend who’s a billionaire.  We all used to spend a lot of time together.  I always regretted that the former lived this crazy life where he saw his kids less than I thought was right because he was always on an airplane in search of his next deal.  He was a bit of a deal junkie.  Yet what I think drove him more than anything was a sense that he was “behind” our other friend.

I live in complete bliss knowing that I likely won’t ever come even close to that level.  It’s sort of liberating not feeling the need to even try.  But I have a wonderful family, a job I enjoy and a life for which I’m grateful.  My life isn’t perfect – there’s always something that I know I should be doing to make it better.  But I choose happiness.  And my main point is that I truly believe that happiness is just that – a choice.

Anyone who has ever been in the room when Tony Robbins is speaking will know what I mean.  You really can’t help but become pumped up when he’s on stage.  I saw him speak at the Twitter conference last year in LA organized by the Parnassus Group.  He emphasized to the audience this point about choosing to be happy.  He said that if you smile more, hold your posture better, mentally FEEL more energized and choose to think happy thoughts you will actually be happier.  He took an entire audience of cynical tech people and brought our energy levels up 10 notches.  Maybe 100.  It was awesome.

I’ve always been blessed with the ability to see the glass as half full and I struggle with people who constantly see the wackness in everything.  It’s tiring.  I do have patience for people who need a bit of reminding but not for people who are perpetually negative.  I choose not to work with people like that.  I’ve always advised teams not to hire bad seeds on their teams.  Bad seeds affect everybody and bring the group’s spirit’s down.  I’d far rather have somebody who performs at 90% but has a great attitude than somebody who’s a 100% performer but negative.

Why is this all top of mind?  I have a close family member with Parkinson’s disease.  It’s a constant struggle to get him to focus on all of the positive things in his life.  Every phone call turns into complaints about how he doesn’t feel well.  I have sympathy.  But he’s in his 70′s and has had a wonderful life.  He still has the ability to walk and he doesn’t shake too badly.  He was diagnosed in his mid 60′s.  I keep thinking what Michael J. Fox wouldn’t have done for 30 extra year’s of normalcy.  And somehow Michael J. Fox gets his chin up and accomplishes things.  So did Christopher Reeves.  And Bethany Hamilton (the teenage surfer who lost her arm in a shark attack) - how many people would have her positive attitude and keep surfing?  How many would lead a life of “poor me?”

My wife reads a blog every day that she loves (and highly recommends to everybody) called The Happiness Project by Gretchen Rubin.  She loves it and always has such great stories to tell me about the blog in the evenings when we talk about life.  Like how most people derive as much (if not more) happiness from planning fun things than from the actual act of doing them.  It’s like travel – you get so excited to plan everything out and you love to show pictures of what you did afterward, but many people struggle to “get into the moment.”  That’s OK as long as you find enjoyment in the before and/or after.

She also talks about how temporary the positive feelings are from great physical possessions that you acquire like a new car.  Happiness from getting things is ephemeral.  So happiness has to be a state of mind.  You need to constantly remind yourself to be happy whatever your life’s circumstances.  I know that some people will think, “sure, that’s because he’s a VC and lives a charmed life.”  My life is no different than most people’s.  I’ve had many setbacks in life – probably more than many of you.

And I couldn’t help but noticing the adversity in this article on NY Times interviewing Fred Wilson of Union Square Ventures:

“Before the sale [of Geocities], we were completely broke. We had to move out of  New York City because we just couldn’t afford to live in the city. We had three kids, and I was barely scraping by to pay the mortgage.

So you were essentially broke?
Yes, completely. Right before the Geocities sale went through, my wife went to the cash machine to buy groceries for the week and there wasn’t any money in our bank account. I told her to put groceries on the credit card because I knew we were going to sell Geocities the following week. But before that happened, we were living hand to mouth.”

According to the math from the post that would make Fred 38 when they sold Geocities – 38 when he was living “hand to mouth.”  Perhaps that’s why to this day he still seems to have such good empathy with startup teams.  When you’ve been through the struggle you appreciate it that much more in others.

I was in my late thirties before I had my first big exits also so I feel like I somehow also still have the mindset of somebody who hasn’t acquired a little bit of wealth.  Yet I live in LA where there’s ALWAYS somebody around you who has more.  You can never compare yourself by that yardstick or I promise you’ll never be happy.

So remember whatever adversity you’re facing, many of the people you admire today have struggled too.  We didn’t all have it easy.  We weren’t all born with a silver spoon in our mouths.  We didn’t all hit it big by 30.

You can choose to be defeatist or to pull your socks up and try again – harder this time.  Enjoy the journey and not just the destination otherwise even when you arrive you may not find the happiness you were looking for, as I suspect my $500 million friend has not (luckily for me he doesn’t read blogs! ).  Read the book “The Alchemist” if you want a reminder about enjoying the journey. Or read the magnificent book “Eat, Pray, Love” and follow the Italian mentality of  ”Il Bel Far Niente (The Joy of Doing Nothing)”.

And remember, whatever adversity you’re facing – enjoy the journey.  Life is 10% how you make it, 90% how you take it.

_________________________________________

** Postscript Note: I have always believed that there are carve-outs to this rule for people with mental illnesses who don’t completely control their minds.  I believe that the chemicals in some people’s brains are hard-wired for unhappiness and that people fall on a scale of depression from severe to mild.  Medicine can help – I’ve seen in first hand in people with whom I’m close.  I’m not trying to be a blog about medicine or depression – I just wanted to acknowledge that for some people the advice in this post will be easier than it will be for others.

Lots of discussion these days about the changes in the VC industry.  Here’s my take:

1. The VC industry grew dramatically as a result of the Internet bubble - Before the Internet  bubble the people who invested in VC funds (called LPs or Limited Partners) put about $50 billion into the industry and by 2001 this had grown precipitously to around $250 billion.

2. But VC is an “illiquid asset” so funds didn’t disappear quickly - In 2000/01 the stock market quickly adjusted punishing investors in the NASDAQ and in individual public technology stocks.  Consumers pulled their money out of these risky investments, but when LPs make commitments to VC funds they make 10-year, legally binding commitments. So as of 2008 total LP commitments were still at nearly $250 billion.

3. The VC industry in shrinking –  Paul Kedrosky was early on the scene with this prescient prediction that the industry would shrink.  What accelerated this was the collapse of the public stock markets.  LP’s who invest in funds are typically university endowments, public & private pension funds, insurance companies, large corporations and very high net worth individuals called “family offices.”  To give you an indication of how bad, for example, university endowments are suffering check out this chart.   You’ll notice that Harvard lost 30% of the entire value of its portfolio.  If you’re interested to read a more detailed piece on how they think about this check out.

So the people who invest in VC funds have two problems.  One is the “denominator problem” which says that if an LP invests X% (the numerator) into “alternative investments” such as venture capital and if their total amount available to invest (the denominator) goes down by 30% then the amount they allocate to VC will by definition need to go down by 30% to stay the same percentage.

The second problem is more troubling.  The VC industry has performed terribly over the past 10 years.  Many firms didn’t even return LPs their original money let alone a profit.  So even within the “alternative class” our LPs are looking at other asset investment choices such as distressed buyout funds, private equity or hedge funds.

VC will shrink.  Oh yes it will.

4. This means that some funds will disappear – Returns are not even.  The top quartile funds have performed well. [side note: our last fund at GRP Partners is currently ranked as the 5th best performing fund of the year 2000.  Our current fund was raised in 2008/09.]  Many funds have not performed and will start to disappear.  This is finally happening because the boom of 1998-01 means that many funds are reaching the maturity of their 10-year funds [strangely, 10-year funds usually last about 13 years!].

The best and most consistent funds in Silicon Valley (e.g. Sequoia, Kleiner Perkins, Accel) can and will easily raise money.  But even great funds that are not in this historic and long-established funds will not find fund raising easy.  This is best told in this amazing and brutally honest piece by Alan Patricof where he talks about the recent difficult fund raising experience at Greycroft [they just raised a $130 million fund].

I was at dinner with a large LP and mentioned that I had heard the industry would shrink by 50%.  She laughed and said, “Our predictions are for a much larger drop.”  Gulp.

5. Funds that raise money will be smaller - There is not only less money going into the VC industry, those that raise funds are often raising significantly smaller funds.  Some funds like Battery Ventures have bucked the trend by raising $750 million.  Others will, too.  But my conversations in the private corridors on Sand Hill Road in Silicon Valley is that many fund sizes will be smaller going forward.

6. This is producing a game of musical chairs –  You know: the music is playing while 8 partners walk around a circle of chairs.  The fund size shrinks by half so half the chairs disappear.  The music stops.  Partners leave the industry.  Some partners don’t have to walk – they just sit down while the music is still playing and therefore other partners need to go.

But equally some partners joined firms in 2000 and have still never seen any upside in cash since their funds haven’t yet returned the initial capital [note: VC funds usually return all of the capital that they raised first and then share 20% of the profits above this hurdle].

I suspect both were at play in Rustic Canyon Partners that went from a $500 million fund to around a $200 million fund.  PE Hub reported that there were defections and the implication was that the fund was “fighting for its life.”  I don’t think this is accurate.  There are some very talented partners remaining at Rustic Canyon and I’m told some committed LPs.  But I also know that some of the partners who left were also very talented.  PEHub followed up their analysis with this.  Think about the math.  It was clearly a game of musical chairs in some cases and in others a case of talented people believing they could make more money in a different job.  After all, most people don’t understand that “venture capital is a get rich slowly” scheme.

7. It takes less to start a business these days – We all know that it takes less to start a technology company these days.  You don’t need to buy hardware – there’s Amazon AWS.  You don’t need to buy expensive software – there are free open source solutions for nearly everything.  You don’t have to hire as many sales people because much can be sold online.  So companies are running for the first 1-2 years on significantly less capital than they did 10 years ago.

8. So super angel and seed funds are proliferating – As a result there has been an explosion in the number of amazing early-stage investors such as Softtech VC, Floodgate, Felicis Ventures, K9 Ventures, OATV, Lowercase Capital, Founder Collective, and many, many more.  There are also super angels that are so numerous I’d rather just link to the best list out there, which is VentureHacks’ AngelList.

9. And VC’s are doing earlier stage deals – And we all know that VCs are doing earlier stage deals.  The most notable is First Round Capital who built their entire fund and model around this type of investment and the notion that exit values in the future will be lower than they were 10 years ago.  They are also the most innovative new fund to enter the market in the past 10 years in my opinion.  There is also True Ventures that does early stage, seed investments.  And of course Foundry Group, Union Square and a whole host of other firms including my own.  I have written more in depth on this topic in the past.

10. This is producing a “boomlet” or a bubble in early-stage investing.  That’s OK. – This massive increase in seed & angel funding caused Paul Kedrosky to predict that there is a coming seed fund crash.  I don’t know whether there is a “crash” coming per se but I do believe that too much money is going into angel and seed companies too quickly.  I’m OK with this – it feels fairly benign.  But one problem it is causing is that early-stage deal prices are creeping up again higher than historic norms.  This smells like classic froth to me.  So IMHO it’s probably more of a mini “bubble” than an impending crash.

11. But it takes the same amount of money to scale a big business and this is where outsized returns are earned – If you want to build a big business you still need big bucks.  Fred Wilson wrote a great piece on this. He acknowledged the importance of the growing seed fund movement in creating a new wave of cost-effective innovation.  He then profiled his portfolio company FourSquare who started with a very small investment.  But now that it’s time for them to scale they need a lot more capital and therefore just raised $20 million from Andreessen Horowitz.  Think about it – while FourSquare has established itself as the clear market leader it is unquestionable that Facebook, Yelp, CityGrid and many more well capitalized companies will be gunning for them.  Staying “lean” is not an option.  If FourSquare wants to dominate it’s market it’s time to GO FAT.

12. Many angels and some seed funds will get burned – In good times it’s great to be an angel or seed investor.  You invest low amounts of capital and the company gets to IPO (96-99) or trade sale (05-08) without raising too much capital and certainly not on punishing terms.  But in bad economies many angels get burned. More money is needed, VCs are harder to come by and when they invest it can be on penalizing terms.  Often if you have deep pockets (or a proper fund) you can protect yourself by getting out your checkbook again.  But this only works if you have deep pockets.  And ironically the one time angels hate to get out their checkbooks is in a difficult market (in part because they’re also feeling it in their real estate investments, stock market portfolio, etc.).  So angel and seed stage investors’ returns will be dependent on good times continuing or on the ability of their portfolio companies to get financed.

13. So forming tight relationships with larger investors in the value chain is a critical skill for investors – The smart angels and seed fund investors know that one of the most important success criteria for an early stage investor is the ability to get the next round of the company financed.  Nobody understands this better than First Round Capital.  I have never seen a fund that spends so much time building relationships with every other VC (in addition to many entrepreneurs.)  Some seed angles and seed funds clearly get it.  Others spend less time on this activity.

I also think that seed funds with a very clear sense of purpose will do well.  One of my favorites is K9 Ventures.  Listening to Manu Kumar speak is like listening to a focused entrepreneur speak (and I can’t say this about all funds).  He has a set of clearly defined criteria in order to invest.  Price MUST be in a certain range.  Team must be purely technical.  Revenue must come from a primary source (as opposed to advertising or other third party sources).  Teams MUST be in the Bay Area.  And so on.  When you listen to his rules you get the sense that he really has a strong thesis for his investments and a belief in how he’ll make good returns.

14. This is especially true if we have a double dip economy – If the economy is in recovery then angels and seed funds are heros.  If we hit a double dip economy then the next phase of their investment cycle begins.  They’ll need to focus on getting portfolio companies funded.  Those that invested narrowly enough and/or have great relationships with VCs will do well.  Those that spread there bets widely or haven’t fostered VC relationships will have some triage work cut out for themselves.  ”Financing risk” is one of the biggest risks for seed stage investors.  This only becomes noticeable in down markets.

15. The reality is that right sizing the industry isn’t enough.  You need to right size each segment of the industry. – While many people publicly predict that the future of investing is about seed investing I think this is wrong.  There is a certain size market for seed funding that should exist.  Excess capital will drive up prices in that segment and drive down returns.  I think this segment has expanded due to structural changes discussed earlier but it still has a natural limit.  Then there is a certain size market for A round VCs, B round VCs and growth equity investors willing to put $50 million to work.

What you’ll see is a natural segmentation of the industry (which already exists) where each segment is right-sized and we’re all inter-related and our successes mutually dependent.  The earlier the stage, the cheaper the price, the smaller the check, the higher the risk and therefore the higher expected return.  So Chris Dixon is right that super angels and seed funds should perform better than VCs – they’re taking higher risks due to an early stage.  But many others won’t navigate these risks well and will underperform.    You don’t get the increased reward without the commensurate increase in risk.

I did a short explanation of this whole phenomenon in this video.  Start at minute 50.30 and run for just a few minutes.

16. Importantly, what does this all mean for startups? As I argue in the same video above – startups are better off by the “right sizing” of the VC industry.  When there is too much money in VC then too many companies get funded and raise too much money.  Try selling your product at a fair price when you have 4 competitors who’ve each raised $10 million in VC and who expect it will be easy to raise the next $10 million.  Over funding drives poor market behavior and makes it difficult for strong players to earn proper returns.  I’m not anti competition – to the contrary.  I just don’t like too much competition armed with large balance sheets funded on speculation and hoping purely for user numbers.

So in the future less of you will likely raise VC money.  You’ll have to find alternate ways of financing your dreams and that’s OK.  But those of you who do get funded will build stronger businesses, make better returns, hire better & more committed employees.  And of course you will produce our next wave of innovation.

We started this week’s show with a Q&A session where I answered viewer questions about fund raising and the VC industry.  If you enjoy this blog I think you’ll enjoy watching the first 14 minutes of this video (just click on the image of me below).  Heck, stick around and watch me discuss the seed funding debate that is going on right now and what is happening in the VC industry overall.  I give a sneak peek at a blog post I’m writing on the topic next week.

I’m going to make this a regular part of the show since it was really fun.  In the first 10-15 minutes of show I answered the following questions:

- What is my greatest exit? – I spoke about GRP’s recent exit of Ulta in which we returned $320 million to our limited partners.  Yes, that was the value that we actually returned as opposed to the value of Ulta.  Great exit.

- Can you please expand on your post about distributed teams? I spoke about the need of the CEO, CTO and head of Products to be in the same location.  No problem to have some developers in remote locations.  It was a verbal discussion on my post on distributed teams.

- Can you please explain convertible debt and specifically how it pertains to angel deals? Convertible debt is a loan to the company that doesn’t typically get paid back but rather “converts” into equity when you raise a larger round at a later date.  If you’re an entrepreneur, all else equal you prefer convertible debt because the deal is priced at a later stage when you’re worth more.  If you’re an angel investor you prefer a “priced” rounds because you want to lock in a lower price given that you’re taking more risk up front.  Think of it – why should an angel fund you to allow you to create more value so that they have to pay a higher price at a later date?   The reality is that due to competition and a desire to keep legal costs down (convertible debt deals are cheaper to implement than priced rounds) there are many deals done with convertible debt.  A good compromise is “convertible debt with a cap” meaning the conversion price has a limit.  If you watch the video I go into greater detail

- What advice do you have for people who want to get into venture capital? Don’t. But seriously, I talk about why VC is a “get rich slowly” scheme and why many VCs make much less upside than you might think.  I talk in the video about the economics of venture capital and how we make money.

We then had a full session with Rick Smith, founder of Crosscut Ventures (along with Brian Garrett).  Crosscut is a seed-stage fund based in Southern California that has been in some hot local deals like ShoeDazzle (Rick discusses how they get in when it was a super competitive deal – great story), DocStoc, GumGum and others.

We talked about the seed fund phenomenon and whether there was a bubble for seed funding as Paul Kedrosky had predicted.  We also talked about whether VC is shrinking and what that would mean for entrepreneurs if true.  This is a great discussion so if you’re interested you can pick up in the video sometime around the 23 minute mark or within a few minutes after that.

Finally we covered this weeks deals. If you’re interested check out the last section of the video.

1. Hi5

2. InMobi

3. Beyond The Rack

4. eMeter

5. Google’s investment in Zynga

Yesterday I wrote a post about top-down versus bottom-up thinking.

There is a corollary to that advice, which is “doing the right things is more important than doing things right.”  Sounds simple but in practice I promise you most organization fall into the latter trap.

Here’s how it goes:

You have a business development group with two people.  They are tasked with “getting deals done” so they race around talking to tons of potential partners inking anything from channel sale deals, product integration, international distribution agreements, co-marketing arrangements, M&A discussions, etc.  You can often measure how many deals were achieved but there often doesn’t flow a steady stream of revenues / profits from these deals.

You have a marketing department with three people.  They’re tasked with doing … marketing.  So they create a task list of all the marketing activities an organization can do: press releases, web site updates, customer case studies, blog posts, daily Tweets, Facebook fan page, attending conferences, etc.  You get a lot of traffic – not always results.

When you hire people in functional roles they want to show that they’re achieving results and results are easiest to measure by tasks accomplished.  But many CEO’s and management teams fail to set clear guidelines on what the company objectives are and make sure that everybody is driving toward the same goal.  It’s actually quite hard to lay out an annual company strategy that is articulate and underpinned by facts.

So many CEO’s just carry on being … CEO’s –>  fund raise, get media attention, attend conferences, hire staff, “set direction”, whatever.  But this leads to organizational drift because staff will continue to produce “work.”

Let me give you an example.  Let’s say you have a marketing department with an incredibly talented leader who knows SEO, SEM, social media and how to hit the ball off the cover on press coverage.  So you generate a ton of traffic to your website.  If the traffic is unfocused you actually can be doing a disservice to your company rather than a benefit.  Your sales department has to have somebody has do deal with these inbound inquiries.  If the people who wind up at your site are not high quality leads, you either piss people off by not responding to them or you respond and burn up your critical resources trying to be helpful to people who are not likely to convert to become customers.

It’s why I’ve often start when running marketing campaigns the most simple of questions:

- with whom are we trying to communicate?
- what messages are we wanting them to receive?
- what is the best channel to reach these people?
- if they receive our message what actions (if any) are we hoping for?
- how will we handle those responses

And the reality is that you might be better off doing less activity but doing “the right” activities really well.  To do the right activities you need to start with a top down assessment with what you’re trying to achieve with your marketing.

Similar with product features.  One of the most important movements in software design in the past few years has been a return to simplicity – a move away from the Microsoft era of every release adding a new 150 unused features.  One of my favorite sayings in this area comes from a portfolio company, RingRevenue, who like to say “ease of use = use and use = revenue.” I love that saying.  If you don’t know WHY you’re adding features don’t do it just because you have a development team.  Better that they work on new initiatives, performance improvements, operational features to help internal management or anything other than just cranking out features for the sake of it.

But the counter case is equally ineffective.  You sometimes find CEO’s who want press coverage, want to speak on important panels or want features that their competitors offer without knowing whether their customers care about these features.  So they direct staff to meet these objectives without considering what the purpose of activity is and what the end result will be. People will certainly follow orders and do the things you ask of them.

Smart people produce high quality work.  As management your job is to make sure that everybody understands how their initiatives tie into the overall company strategy.  Do the hard work and try to define your companies objectives and get them on paper.  Everybody should be able to answer the question, “why am I doing this?”  Otherwise they’re likely to be doing things right, but not the right things.

For the first 5 years of my career I was a “bottom up” thinker and worker.  I assembled tons of data, grouped things, found results and drew conclusions.  It was difficult to make the transition to a “top down” thinker but as a senior executive – and as an entrepreneur – you’re far less effective without this skill in your arsenal.  You need to be able to structure problems / solutions at the appropriate level to communicate effective and drive decision-making.

The difference is in formulating hypothesis then testing conclusions / data vs. assembling data and finding patterns.  I know it might sound a bit esoteric so let me explain:

I started my career as a programmer.  We did big, boring but necessary implementations for large companies.  I started by doing billing systems.

In billing we literally started thinking about all of the types of bills that would be generated for customers: full payment, partial payment, split payment, senior discount, student discount, level pay plan, etc.  We then made groupings of the common features of each piece of logic so we could figure out what “shared services” we could build so that we could have reusable code.  This is bottom-up planning.  It is useful in many situations and was useful to me in this situation.

I next moved into system design where I designed computer systems to deal with large industrial natural gas customers and telecommunication companies.  I had to understand their business requirements and document them all.  I had to understand all of the normal business rules as well as all “edge cases.”  Again, I grouped them into related functions and then designed systems to handle the rules.

I spent the first 5 years of my career as a “bottom up thinker.”  It was appropriate for my job and stage of career.

Post MBA I went into strategy consulting where my job was to problem solve for clients.  Often I had a very limited time.  Clients wanted to see “preliminary findings” in 4-5 weeks and final results in 8-10.  This is a problem for a strategy consultant because you are, by definition, a generalist that is thrown into new problems again and again.  I struggled on my first few assignments.  It took too long for me to get around to speak to every departement, get data, assemble it, analyze the data to formulate conclusions and then communicate it to executive staff.

The wisest mentor I ever had was Ameet Shah, my partner on several projects.  He taught me much that I know about critical thinking.  He coached me that I had to start with the answers.  WTF?  How can I START with the answers?  How can that be effective?  ”Well, we know the basic structure of the problem we’re trying to solve and we have hypotheses about what some of the answers will be based on our experience.  You need to put this all down into a structured diagram from the first week with the answers that tie to the logic of the problem we’re trying to solve.”

Heresy.

But he had more insight, “once we know the structure of the problem and our solution we can plan the data that proves or disproves our theories.  The key is not to be wedded to our original answer.  But by problem solving in a ‘top down’ manner we can be much more focused about what data we collect.  We can also begin to socialize our answers with people in the company to get their reactions.  That alone will help us solve the problems.”

It was very difficult to get used to it because I didn’t think I had it within me to do this kind of top-down structured thinking.  I bought the most popular book on the topic, “The Mind of the Strategist” by Kenichi Ohmae, who is ex McKinsey.  I found this book very useful but still a little bit hard to implement.  I’m glad I read it though.

I later took a course with Barbara Minto (who taught McKinsey people) and bought her book “The Pyramid Principle.”  This was a breakthrough for me.  It is about structuring your thoughts, presentations and communications.  You group items into component parts in a top-down manner.  The book is expensive but for me personally this helped me enormously.  This and frankly a lot of practice.

But I approach problems in a different way now.  I start with answers and structure what I think the organization of the problem is.  I then try out my solutions by interviewing people to “prove or disprove” my conclusions.  I’m never right the first time so I spend time adjusting my frameworks.  And if data is required then I apply actual data to my conclusions.  The process is bankrupt if you simple tweak the data to support your hypotheses.

But applied correctly and this is golden.

I often go into meetings with portfolio companies with a structure worked out of what I believe the critical issues are.  I structure it top down so we don’t get bogged down in the details that are irrelevant.  To give you an example it might go something like this, here is a made up situation that a portfolio company might face:

- we currently sell through channels
- we’re the market leader in signing up our channel partners
- but not enough volume of business is yet going through the channels
- our three options are: spend more time helping the channel sell, spend more time with customers bringing them into our channel partners or sell direct
- my guess is that we aren’t prepared to sell direct because that would require a broader team and more capabilities than we have.  So the real question is – do we spend more of our time and limited resources helping our channel or educating and marketing to their customers
- on a less critical path we should evaluate the capabilities required to serve customers directly if we ever needed to and know what the channel’s response would be
- discuss

If I framed the issue incorrectly I haven’t done my job.  If it requires minor tweaks we change the discussion on the fly.  But we have the roadmap for our discussion and don’t have to wander on the back roads of unstructured conversations.  I needed no data for this discussion.  It is at the appropriate level.  It drives the conversation to what matters.

I know it sounds exceedingly easy.  It’s not.  And few people in my experience do this well so many board meetings wander.

I challenge you to consider whether you’re top-down or bottom up.  In analysis there are always circumstances for each approach.  But in leadership and entrepreneurism the top-down approach will be the right solution more often than not.