ProfessorVC

Rebuild our Inner Cities one Venture at a time?

2012-01-19T09:53:00.000-08:00

As an active participant in the Silicon Valley new venture ecosystem and entrepreneurship educator, I'm intrigued by the recently announced program Venture for America (VFA). VFA is sending high achieving recent college grads into small businesses and start-ups in inner cities.

Conceptually, this is very intriguing and goes against the current popularity of accelerators in start-up hubs (Silicon Valley, New York, Boston, Seattle, Boulder) that are filled with recent grads and drop outs looking to build the next web sensation. I am a big fan of the accelerator programs and while most of the companies coming out won't be successful, many will, and all of the graduates will receive a tremendous education. Many will likely be successful in subsequent ventures and you can't start your second company until after you've done your first.

VFA is taking a different approach to fostering entrepreneurship. It is modeled after Teach for America (TFA), a program that sends high achieving college grads into inner cities as teachers. These have become very high sought after jobs as TFA has been successfully recruiting students that would otherwise be going to McKinsey or Goldman Sachs. Rather than spending 80-100 hours per week on Wall Street, these students spend 80-100 hours per week creating lesson plans and learning how to teach disadvantaged children. While certainly a laudable mission, I question how many of these teachers actually remain in the career vs. using TFA as the golden ticket to Stanford Business School, Harvard Law or other select grad school.

VFA's tagline is "Mobilizing graduates as entrepreneurs" and is "A program for young, talented grads to spend 2 years in the trenches of a start-up with the goal that these graduates will become socialized and mobilized as entrepreneurs moving forward." In an Inc magazine article on VFA, one student is quoted:

I've applied to a ton of companies," she says. "I have this entrepreneurial mindset that I have to work at a start-up and do marketing, but every company I have applied to, whether it was a start-up or not, said they found someone more qualified or I didn't have enough experience."

Nothing against Ashley from UVA, but that is not how you go about finding a job in a start-up. You network! You attend start-up events! You go hang out at the engineering school! You find companies you are passionate about and where you can offer solutions to problems! You don't send in a bunch of applications. Is this the kind of individual that is going to create jobs in inner cities? I don't know, but I'll bet against her.

Couldn't you accomplish the same thing within the university environment? That is what I am doing with the ELAB program at San Jose State University. (Entrepreneurship Lab Provides Students Work Experience in Start-up World) We have had 50 students through the first four offerings of the program and almost 50% have received job offers at the end of the semester for either full time jobs or paid internships. All have received tremendous experience not available in a typical academic setting.

Back to Venture for America. I hope they are successful in creating companies and jobs in inner cities. Clearly, we live in a bubble in Silicon Valley and our economy is rarely in sync with the nation as a whole. If the rest of the country were experiencing the new company growth, hiring challenges, decreasing office vacancies and rising rents that we are in the Bay Area, the economy wouldn't be the top issue in the presidential campaign. In fact, nobody outside of the far right would care about the Republican primaries as Obama's reelection would be a fait accompli. Politics aside, as the Beach Boys sang, "Wouldn't it be nice"...

Crowdfunding - Good Idea or Really, Really Stupid Idea?

2011-11-14T11:05:00.000-08:00

Last week, the House of Representatives passed the Entrepreneur Access to Capital Act (H.R. 2930), commonly referred to as Crowdfunding. Since small businesses are responsible for the vast majority of new jobs, legislators believe that these new rules will make it easier for entrepreneurs to raise capital and ramp up hiring. In theory, this sounds like a great idea. However, in practice, this will be very bad.

I won't go into the details of the bill, but at a high level, it allows entrepreneurs to raise funds over the Internet up to a maximum of $1M annually (or $2M with audited financials). Maximum investment from each individual investor would be the lesser of $10K or 10% of annual income and investors do not need to be sophisticated. These investments would be exempt from registration under the 1933 SEC Act.

There is a reason the SEC exists. I can't remember if the SEC was one of the government agencies that Rick Perry wants to get rid of (but neither can he), but it seems like this is the exact type of investor that the SEC was set up to protect. Angel investments are highly risky and I would estimate that over 90% provide no return to equity investors. This is why 25-30 investments are required to achieve proper diversification as an angel. 10% of an individual's income is a very high amount and there will be many scenarios where non sophisticated investors will invest in multiple companies and going over the limit by simply checking a box in an internet form.

You may be thinking, "Ah, ProfessorVC is concerned about more competition in his angel deals". I like the way you are thinking, but not true! At the end of the day, very few entrepreneurs say "I wish I had raised less money"...and very few angel deals are truly oversubscribed, no matter what the press release says. More funding at the seed level is a great thing! Just not from investors who can't afford to lose the cash.

I often speak on panels and am often asked questions about what are the qualifications to be an angel investor. My response (only partially tongue in cheek), is to hold a $100 bill on one hand and a lighter in your other. Light the bill. Are you calm? If so, do it another 5-10 times. If you are still ok, then you are probably fit to be an angel.

Clearly, there are benefits to making it easier for entrepreneurs to raise seed funding. I'm an active participant on AngelList a fan of the excellent accelerator programs (YCombinator, 500 Startups, TechStars, AngelPad, etc.), and an investor in Right Side Capital Management (RSCM). RCSM is seeking to add scale to angel investing through a highly automated screening, evaluation and diligence process.

However, I'm just not comfortable with where this legislation is going. Crowdfunding will likely be well received by scam artists and lead to many startup investment pitches in your spam folder along with those for viagra and male enhancement. More importantly, this could lead us down the road we've already traveled with day traders and real estate flippers...At the very earliest stage, this is the realm of friends & family and if you are comfortable taking investment from your fraternity brother, not so rich uncle or brother-in-law, be my guest.

Card Counting for Investors

2011-09-26T14:32:00.000-07:00

How would Billy Beane have done as an early stage investor?

I haven't had a chance to see Moneyball yet, but did read Michael Lewis' book when it came out eight years ago. However, I have seen some blog posts posing the question about whether the same principles of valuing baseball players could be applied to entrepreneurs.

Dan Frommer, in Moneyball for tech startups, interviewed Fred Wilson, Chris Dixon, Paul Graham and Ben Horowitz on the topic. According to Dan, the consensus "seems that this sort of technique is possible. And given that four of the most important tech investors in the world seem skeptical of it, if someone can figure out a good formula that works, they may be able to exploit it".

Well, I think I know the guys that can do it! I've written previously about Right Side Capital Management (RCSM), the latest in my post earlier this year, "How Much Diligence is Due..." (Full disclosure: I am an investor and adviser in RCSM.)

RCSM's premise is that they can reach an investment decision (and valuation) based on an application completed by the founders and take gut feel out of the decision process. Below is a short description of their philosophy:

"The part of our philosophy that makes us most different from other startup investors is that we don't believe gut feel is a reliable indicator of potential at the seed stage. Humans are just not very good at simultaneously integrating that much uncertainty to form a judgement. So we focus on specific aspects of a proposed venture that we can evaluate with minimal ambiguity. Over time, we plan to build increasingly sophisticated evaluation methods based on hard evidence."

I'm still not convinced that "gut feel" isn't a good way to invest at the early stage, but this can certainly get rid of over-thinking and provides diversification and investments in entrepreneurial teams that would be otherwise overlooked. They have launched a valuation tool that is free to try out. I encourage entrepreneurs to give it a shot and let me know what you think.

RCSM is also participating in the TechStars funding alliance that will be providing an offer of $100K in funding upon acceptance into the program. This will give RSCM the opportunity to test out their process on the large number of TechStars applicants.

Also interesting that some of the guys behind RSCM are professional poker players who have a deep appreciation for odds and statistics. In the trailer below, Brad Pitt in describing the new player acquisition philosophy, says "we are card counters at the blackjack table we're going to turn the odds at the casino"

I look forward to checking out the movie and seeing if RSCM can exploit the odds on early stage investing.

P.S. ProfessorVC is happy to have been included as one of the 50 Best Professor Blogs

Waah...Do I have to build a financial model?

2011-08-26T15:15:00.000-07:00

I get asked this question a lot by entrepreneurs (and students). I often feel like a Dad (which I am to two wonderful teenage daughters) when I respond, "Yes, because I say so"...Everyone seems to know someone who has raised huge amounts of venture capital without ever putting together even back of the envelope projections. The objections range from "it's hard", "nobody believes them" to "all hockey sticks look alike". To that last one, there is certainly some truth as the standard time vs. revenue chart in most business plans looks like this:

I'm not teaching Entrepreneurial Finance this semester for the first time since Fall 2007. However, I am teaching the ELAB and a new experimental course (The Silicon Valley Experience) for the MBA program. Since I won't have the opportunity to lecture students on this topic until the spring semester, I'll share some of my thoughts here and perhaps can have a dialog on the topic. High level, building the financial model forces the entrepreneur to:

Validate the concept and business model
Determine financing needs and key milestones
Build credibility with investors

I used to also argue that it supports your proposed valuation, but on an early stage deal that is a bit far fetched to get in to a valuation discussion based on your pro-forma projections. The importance is what is behind the numbers. How do you think? What are the key drivers and metrics? Is the model consistent with the business plan? Does the business model make sense? Do you understand the business and market? The process of building the model forces you to answer the difficult questions related to the business model and give a complete picture of the opportunity. Most importantly, how are you going to make money? What did you expect from a long time start-up CFO?

Related to this, I got an email from an entrepreneur this week interested in meeting with me. Unfortunately, I don't have time to take all of these requests, but always try and help where I can so offered to respond by email. Thought it would be appropriate to share his questions and my answers below related to the topic at hand:

The main questions have to do with presentation of documents to VC's.

1.) Does a complicated sales build model make sense for a pre-revenue SaaS company? Analyzing each step of who comes to the website organic, paid, conversions etc

[SB] Having a bottoms-up model is helpful. Of course, this is all hypothesis at this point, but you want to make sure that your assumptions are consistent with market realities for other SAAS companies. Byron Deeter has a good blog post on SAAS metrics.

2.) How should you include market comps? I don't like doing top down models, but I want to make sure the numbers are based on the other people in the markets.

[SB] It is good to have a top down that is consistent with your bottoms-up, so I’d recommend doing both.

3.) How much needs to be shown in the form of a cashflow statement, and balance sheet? Also, do you show accounts payable/receivable in these as they are not accurate or real?

[SB] I include all of the statements in my models to be complete, but nobody should care about this on a prospective basis. For actuals or short-term projections, much more important. When I look at a model, I care most about the assumptions around the business model. I want to get a good idea of the drivers and what is most important for success. I also want to know how you think about the business and how well you know the market, which becomes apparent through how the model is constructed.

4.) Would you put the assumptions/variables on one page that drives the numbers throughout the spreadsheet, or do you put them above each month so they can be altered monthly.

[SB] Ideally, it is good to have all of the assumptions in one tab, so it makes it much easier to do sensitivity analysis. I like to have one tab with assumptions and one tab with summary financials and key metrics. If the model is constructed properly, you don’t really need to look beyond these. I also typically, write a text document summarizing the assumptions, validation for the assumptions and key metrics. However, sometimes (particularly in the early periods when annual is too long a period), you may want to have some of the assumptions on a monthly basis within the appropriate tab. I often do this in the revenue tab.

Hope that was some helpful advice from ProfessorVC. Feel free to chime in with your thoughts.

I'm heading up to the mountains with the family this evening and should probably get ready for that other common Dad question coming from the back seat, "When are we going to be there?"

One final note: After labeling myself as "the last blogger in Silicon Valley", I am now doing the same thing on twitter. Wanted to make sure it was going to catch on...You can follow me @professorvc, and hopefully will comment more frequently than this blog.

How much is enough?

2011-06-20T13:41:00.000-07:00

Financing, that is...I had mixed emotions when I read the the press release on the recent funding of iControl Networks.

I was the founding CFO for iControl and spent over 4 years with the company (the reason I call myself a part-time CFO and not interim as I tend to remain longer than most permanent CFO's...) Since the iControl system chronicles all meetings, I was able to find the automatic picture snapped from my first meeting with the founders, Reza Raji and Chris Stevens on April 22, 2004.

Now that iControl has raised over $100M, this got me thinking back to our original business plan. One truth of start-up financing is that it generally takes twice as long and twice as much money to accomplish your milestones. I took a look back at our original financial model we presented to VC's in 2004. The business model (OEM through broadband and home security companies for mass distribution) if not specific product functionality has remained largely the same. But of course, the model had us requiring only $10M equity to breakeven and to achieve $185M in revenues in 2008 (the magic Year 5 in all business plans).

I am no longer an insider, so don't have any view into current financials, but do know that total financing is now 10X the original plan and at the current accelerating growth rate, revenues will still not hit that $185M until 2012 or 2013, so double the time. And this is a company that has managed to get an A+ list of investors and is executing very well. Most companies don't come close to their rose colored financial models prepared when going out for Series A financing.

There are definitely some lessons in the story for entrepreneurs and angel investors, but before discussing, I thought I'd share a bit about the early financing history for iControl. Before the $52M Series D, the $23M Series C, the $15.5M Series B and the $5M Series A, there were angels writing checks with many less 0's. In looking back at the old financials, at the end of Q2 2005, our cash balance was a whopping $546. At this point, Reza and I were funding the company to keep the lights on and servers running. We had spent the $275K raised from our original angels and were actively speaking to any and all angels and VC's we could convince to meet with us. In fact, since the iControl system was busy taking pictures of all entering our conference room, we could put together a photo album of all these meetings.

At this time, we had secured a term sheet from a co-investor from one of my other angel investments (Thanks, Graeme!) offering to invest $75K if we could find another $250K by September 30, 2005. We managed to pull together an angel syndicate and close $450K on 9/30 after working the phones the last few days and anxiously waiting for signature pages to show up on the fax machine and wire confirms to hit the bank account. Less than a month later, we received a term sheet from Charles River Ventures for the Series A and as they say, the rest is financing history...with investments from Intel, Kleiner Perkins, Cisco, GE, Comcast, ADT, Rogers, and others.

So what does this all mean. As I said up front, I have mixed emotions about the financing. While my ownership stake in the company has been diluted through these financings (and the merger with uControl), my carried interest (paper value of my equity) has been going up with each increase in valuation. However, each financing resets the clock as new investors are looking for a multiple of their investment on exit.

Entrepreneurial finance (I should know since I teach the course) is all about options. Staged financing gives investors options in deciding whether and when to invest more and gives entrepreneurs options in how much to raise and when to think about exiting. While bootstrapping, there are multiple options from doing as a side project, changing the business, raising angel or venture, etc. Once you raise a small angel financing, you still keep many of your options, but are now committing to a growth path with an eye towards eventual liquidity. A talent acquisition or bootstrapping are still options, but need to include buy-in from the investors. Once you raise venture capital, you are forced on a path to spend ahead of the business and seek the highest growth business model options. In iControl’s case, there were exit options at different stages, but now with more than $100M invested, the only options where investors will be happy will be an IPO or $1B+ acquisition, which greatly limits strategic options.

Is $120M enough capital to reach these exit goals? I sure hope so, but we'll have to wait and see how the founding team and angels come out at the end of the day. Stay tuned...

Why I Hate Convertible Debt...Let Me Count the Ways

2011-04-07T13:33:00.000-07:00

My partner in Menlo Incubator, Gary Kremen, and I had a recent debate on which one of us hates convertible debt more. We weren't able to declare a winner, but I did agree to write a blog post on the topic. This will also serve as a good pointer for all the entrepreneurs who ask why I am not interested in their company led convertible note financing round.

I thought about doing this in a top 10 format, but will limit to my top 3 reasons:

Misalignment of incentives - As an angel investor I want to do everything I can to help the entrepreneur succeed. In a convertible note structure, I'm penalized for increasing your valuation. Instead of getting a 2-3x multiple from seed to Series A, I get a discount off of the Series A, so I'm better off financially with a lower valuation. Investors are taking all of the downside risk and not getting the upside.
Is This a Bridge or a Pier? What is the debt converting into? At some point, the debt has to convert or be paid back. Convertible debt can be like a drug - "just a little bit more and we'll hit that milestone". I've seen a number of entrepreneurs, angels and VC's fall into the trap of providing debt in small pieces. It all adds up and the more you have the bigger the round needs to be justify the valuation based on new cash in.
Why Invest in an insolvent company? Technically, the start-up is insolvent from the day they take the first dollar of investment. This can make it much more difficult to get any bank financing, new investment, and trade credit. Most entrepreneurs don't realize this, but they have actually given a lot of control to investors with convertible debt. Depending on how the transaction is structured, investors could block a financing and potentially take over the intellectual property. Most don't have any interest in this, but why take that risk that one of your investors may decide to call the note.

The arguments for convertible debt are that it is quick, easy and cheaper to get a financing done. There isn't a need to negotiate a number of terms in standard preferred financing documents and legal fees will be less. From my experience, negotiating debt deals with an experienced investor will result in a number of the same terms and won't save much (if anything) on legal fees. Particularly, now that standard Series Seed docs are commonly used.

So when does convertible debt make sense? In cases where it is truly a bridge financing (i.e. venture term sheet negotiations in progress with strong likelihood of closing), I'm willing to take that risk and don't deserve a ton of reward for taking the additional risk at that point. Also, for first money in from friends & family, it makes sense. In some cases, where the round is very small ($100-$200K), it doesn't make sense to price. However, I would generally look to increase the size a bit and price if I were involved.

There was a good post recently by The Funded, "The Year of the Start-up Default" that discussed the potential ramifications of all of the convertible debt outstanding now. There are probably thousands of companies that have taken convertible debt in the past 18 months. Most of these are not going to raise venture financing, get acquired or become profitable. Even the ones that do get to cash flow breakeven, will not likely be in a position where they could pay back the debt. So what happens to these companies? Some will just shut down. Others will attempt fire sales. Many others may end up filing for bankruptcy or doing an assignment for the benefit of creditors (ABC).

You may say, if you are investing in the next facebook or google, why care about valuation? The returns are going to be so big that you want to have a piece of the best deals rather than more ownership in companies that aren't going to do well. That seems to be Paul Graham's (YCombinator) argument. However, using portfolio theory, your losers are going to far outnumber your winners, so taking half or more of the gains out of the winners will have a big impact on the overall returns.

So, the next entrepreneur that tries to convince me that a convertible debt is good for everyone, I'll say, "Let's figure out how much money you need to get to a significant milestone, raise the funding, price the round, and work together to build value. If we're successful, everyone wins. If we're not, let's go down on the ship together and hopefully stay out of those lawyer (I mean shark) infested waters..."

A Lot of Horn Tooting over a Kazoo sized deal

2011-02-18T13:20:00.000-08:00

The LinkedIn acquisition of CardMunch a few weeks ago caught my attention. Techcrunch called it one of the "most like-minded and forward-thinking acquisitions I’ve ever seen"

I met with the founders of CardMunch several months ago when they were out raising their Series Seed round. They have a cute little app that takes a picture of a business card, populates your contact database and data is confirmed through crowd sourced labor. This is a cool way to solve the stack of business cards sitting on your desk and through geocoding lets you know where you met. You can also spread dozens of cards across a conference table and snap away.

I liked the founders (Bowei and Sid) a lot more than the business. CardMunch seemed like a nice feature and wasn't clear if there was even a product, let alone a business. It was going to be challenging to get scale with a model that charged on a per business card basis, a requirement given the amount of funding and cost for the crowdsourced labor. I generally only invest when I can think of at least half a dozen potential acquirers off the top of my head. In this case, LinkedIn was the only logical one that came to mind and didn’t see a viable business model short of that result.

Given that, I wasn't completing surprised when Linked-in announced the acquisition last month. I assumed they weren't able to raise funding and early exits often work out great for the founders, although not necessarily investors. However, after reading some of the press and tweets by investors, I began to wonder if this was a much bigger outcome than I would have guessed. A stock acquisition is a bet that would provide significant upside (and possible downside) opportunity.

I was curious about the sale price (not announced in any of the acquisition articles), but was disclosed in Linked-In's S1 filing at cash proceeds of $2,394,000. Seemed like a good time for ProfessorVC to do a little digging to see if there was more than met the eye.

I first contacted my friend, Manu Kumar, who incubated the company, coming up with the idea and finding the founders to build the product. He obviously has a founder's common stock stake along with cash invested. I asked him how the deal came out for investors since the sale price was significantly lower than the valuation on the round they were raising when we met. It looked like the preferred investors would get their money back and the founders would get a nice payday for a year's work. Nothing wrong with that and something that Basil Peters writes extensively about in Early Exits.

However, Manu's response made it sound like there was more there (or possibly a shovel involved):

"Steve,

There was *a* number reported in the LinkedIn S-1, but that doesn't tell the complete story. Other than complying with the filing requirements for the S-1, the terms of the CardMunch deal are private, and we are not allowed to discuss them.

At the time when you met with the CardMunch team, we'd already raised some amount of capital for the seed round. We stopped the fund-raising mid-way once we were approached by LinkedIn and engaged in discussions with them. The transaction was actually a great exit, and *everyone* (including the Series Seed investors who came in less than 2 months before the exist) made money on the transaction. It was a brilliant exit -- from start to finish in 13 months! :)

Regards,
-Manu"

Ok, so maybe there was more to the deal than announced, but typically the S1 would include contingent payments (outside of the normal 20% escrow) such as earnouts or stock. I began to wonder based on the "*a*" number comment that perhaps Linked-in had thrown in a sweetener to the investors, such as an opportunity to buy some secondary shares pre-IPO or an allocation in the IPO. Given the issues we had in the past around allocation of IPO shares, this would be a very sensitive issue. Mind you, this is clearly speculation on my part (what are blog posts for?) and has no basis in fact.

Time to do some more digging. I ran across a couple of blog posts by another angel investor in Card Munch, Ty Danco. One was on the acquisition and the other on his original investment. I posted a comment on Ty's blog regarding the economics of the deal and was surprised to find that he had deleted some of my speculation and added the following comment:

Ty’s note: I’ve edited the rest out, as Professor VC asked specific valuation questions, posing some questions I can’t discuss. Sorry, but as is the case often in sales where the buyer has bigtime legal counsel, I’m precluded from giving out details.

Thus, I am raising my questions here. Perhaps, there is more to the deal or maybe it is just a face saving gesture on the part of investors.

Why can’t anyone just say, “it wasn’t a great outcome for investors, but was for the entrepreneurs and glad we could help make that happen”. I guess nobody wants to pull a kazoo out of their pocket when it feels so much better to blare a trumpet.

How Much Diligence is Due...

2011-01-27T23:11:00.000-08:00

...Or are investors better just rolling the dice. I've addressed the due diligence question in previous posts, but this came up again in a debate we were having at a recent meeting of the Sand Hill Angels. A blanket statement was made by one of our members that there was a direct correlation between the amount of diligence done and returns on angel investments. And in order to increase our group's returns, one of our goals should be to get more people and man hours involved in the diligence process. I immediately jumped up and called "bullshit"...

I strongly believe (at least for very early stage technology ventures) that you will get diminishing returns and arguably negative returns once you get past an initial threshold of team, product, market and financial diligence. There are so many unknowns at this stage and the only known is that the business model is going to change at least once, or in the current most overused term in the Silicon Valley, there will be a "pivot".

It turns out the statistics related to returns were from an oft cited study on returns to investors in angel groups sponsored by the Angel Capital Association with research by Robert Wiltbank at Willamette University. The research did show that higher returns were earned by investments where more diligence was done. However, the bar was set very low at 20 hours as the determinant whether high or low diligence was performed.

The average number of angels per investment was 6, which pegs the average time at just over three hours per individual. This could include 2 short meetings and a couple of phone calls. Not exactly extensive diligence. This feels about right for an early stage angel investment and no reason that the process needs to drag out for months and even weeks. The key to getting deals done and investing in the best deals is the ability to make quick decisions and this is where angel groups have deservedly earned a bad rap.

This brings me back to a post a wrote about a year ago titled "Would a Dart Board Provide Better Returns?" I wrote this right after I had read about a new fund, Right Side Capital, that planned on investing in 100 companies a year without ever meeting the team or vetting the idea. Instead, they are going to rely on an algorithm to select companies. The formula will be based on the founders' experience, schools they attended and other background information to gauge the likelihood of success. So, after my initial reaction of "Are they friggin serious?", I became intrigued by what they were doing and spent several hours with the team and looking into their research. If you want to skip to the end of the story, I ended up becoming an adviser and investing in the management company.

So, what ended up causing this about face? Part of it was the out of the box thinking and turning the typical venture investment thesis upside down. You can find a collection of their research on their site and some compelling analysis by RCSM partner Kevin Dick on his Emergent Fool Blog, "You Can't Pick Winners at the Seed Stage" Through their research, they came to two Big Realizations:

People matter ideas do not - It is impossible to try and pick the best ideas and if you do, you will invariably screen out revolutionary ideas as crazy
The market's risk can be mitigated without reducing the return - This is really basic diversification theory on steroids, that instead or requiring a basket of 20 public equities as you would in a typical asset allocation strategy, in the seed stage you need hundreds of investments, which will smooth the risk curve

Kevin quotes early and often from the Black Swan by Nassim Nicholas Taleb

Black Swan Theory, according to Taleb, almost all major discoveries and undirected and unpredictable. In the context of angel investing, the best way to play is to diversify across a broad spectrum of technologies and geographies. Since it is extremely difficult to predict, this will give the best chance of hitting the winners.

Not totally surprising, some of the early backers of RCSM are professional poker players, who obviously know a bit about playing the odds. I'm hoping this roll of the dice comes up 7's.

Don't Stop Believin'

2010-10-26T17:02:00.000-07:00

With Game 1 against Cliff Lee and the Texas Rangers tomorrow, the Giant's bandwagon is so full now, it's hard to find a seat. So why is ProfessorVC writing about the Giants? Do I need a reason?

On paper, the 2010 Giants shouldn't have finished in the top half of the national league, let alone won the division and the pennant. With Timmy, the Beard, Smiles, Kung Fu Panda, Juan "a lot of happy" Uribe, they are just a fun team to root for.

I had the opportunity to hang out with the left field bleacher crowd last Tuesday afternoon at Game 3 against the Phillies. Just one big party in Section 139 led by the guy in the picture above waving the giants flag and the guy in front of me leading the "What's the matter with Ibanez....He's a bum" chant.

So back to the entrepreneurial discussion. A couple of things came to mind. The first is Ashkon Davran's cover of Journey's Don't Stop Believin' ,which has become the Giant's theme song during the postseason run. If you haven't seen it yet (and to date over one million folks have), it is worth the 3 minute stop before finishing this blog entry.

Was that awesome or what? According to today's San Jose Mercury, Davaran has been trying to break into the music business for the past three years and after the release of this YouTube hit, has started getting calls about new projects. Entrepreneurial tip number 1: Follow your passion and you never know where it will lead.

The search for a world series ticket brought up some more thoughts about entrepreneurial finance. Got me thinking again about how I passed on investing in StubHub. I've written about this before and I certainly wasn't the only one, but what a great business. There are currently 5,492 tickets listed on StubHub for Game 6. That is well over 10% of capacity and certainly answers the chicken and egg question founder Jeff Fluhr was asked many times in the early days. Not only are many season ticket holders and those lucky enough to have grabbed standing room only tickets in the online lottery, but ticket brokers (theoretically StubHub's competition) are very active sellers in the marketplace.

Let's do some quick math. Out of those 5,492 tickets, let's assume 10% end up selling through StubHub at an average price of $800/ticket with combined buyer/seller fees of 25%. StubHub's take would be over $100K for one game! At a 90%+ margin with minimal risk. Now that's a money machine eBay acquired.

So, I've never been a Journey fan. In fact, I was at the Rolling Stones concert at JFK Stadium in Philadelphia in 1981 when Journey got booed off the stage. Of course, booing is second nature for the denizens of Philly, infamous for having booed Santa Claus at an Eagle's game. Even so, I just switched my ringtone for the next couple of weeks to Don't Stop Believin...Go Giants!!!

Is There Any Truth in "The Social Network"?

2010-10-11T23:35:00.000-07:00

Got around to seeing The Social Network this past weekend. While the flick has gotten rave critical reviews (93% on Flixster), the question of what percentage of the movie is true has also gotten a lot of discussion in the blogosphere.

One thing that can be agreed upon is that is an entertaining movie and well worth $10 (or $11 with Fandango). The move topped the box office for the second straight weekend and has grossed $46M in less than two weeks. If you haven't seen it yet, can check out the trailer below.

I did a little searching around the web to try and find a truth vs. fiction comparison, but the closest I found was "The 10 Most Glaring Lies In 'The Social Network'" on the Business Insider. However, most of these are so minor that it is difficult to argue that they don't fall under artistic license. For example, the movie shows Sean Parker (a stellar performance by Justin Timberlake) arrested for cocaine possession at Stanford. According to the Business Insider, he was actually arrested in a different place and time. Co-founder Dustin Moscovitz is referred to as a programmer, but he is actually an operations guy. Aaron Sorkin sure missed that one (insert sarcasm here)...

Of course, they left off one of the biggest inaccuracies in the entire film, which my wife noticed right away. Several weeks after Zuckerberg and the team move to Palo Alto for the summer, co-founder Eduardo Saverin finally pays a visit. Zuckerberg forgets to pick him up at the airport and Saverin shows up at the front door dripping wet with rain pouring down. As my wife said, who would ever believe it raining in Palo Alto in the summer? She was also amused by Disney actress (Brenda Song of the Suite Life of Zack and Cody) having sex in the men's room of a Cambridge bar.

Did I mention how great Timberlake was? The scenes in the NY restaurant, Stanford dorm room, and Facebook office were some of the funniest in the whole movie. Got me thinking back to one of the best start-up pitches I ever saw. It was early in 2005 and the company was Facebook. Sean Parker showed up about an hour late and gave an incredibly compelling pitch about the business, growth, etc. Unfortunately, wasn't an opportunity to invest at the time.

Ok, so what are the lessons here.

Be careful what you write in email, chat or text. It could come back and hit you in the face during a deposition
Make sure that your co-founders have the right skills and commitment before doling out equity. Also, be sure to include vesting for all founders.
If there are any promises (written, verbal or otherwise) regarding equity, address early rather than later.
Once you become rich and/or famous, anyone you have wronged throughout your life will surface

One other thing. Not saying Zuckerberg took the high road in any of this, but Facebook was all about the execution and not the idea. At the end of the day, the settlements were a relatively small piece of the company, but a huge windfall for those who sued. Whether true or not, at the end of the day, just doesn't matter.

Are DEMO's days numbered?

2010-09-16T08:45:00.000-07:00

Has DEMO lost it's luster and relevance in 2010? I spent the past couple of days at the conference and certainly felt like it. There wasn't a lot of buzz in the air. This was the 20th Anniversary and possibly the last.

DEMO has always been one of my favorite tech conferences. All product, all the time. You can always check out the current and prior product demos at the DEMO site. The conference has launched a number of great companies including Tivo, WebEx and Palm, and historically draws top press and investor attendees. Also puts a ton of pressure on the CEO's to have a well rehearsed 6 minute pitch and hope that they don't end up in Demo Hell. One poor guy completely blanked on what his company did and after stammering for 20 seconds, pleaded with the crowd to come to his booth and find out what they do.

With all of the new ways to see early companies such as TechCrunch and YCombinator, I had a feeling that much of the luster was gone and debated whether it was worth the time to attend.The last time I went to DEMO was in 2005 for the launch of one of my companies, iControl Networks. It was the 15th anniversary and they made a big deal branding the event as Demo@15. This year, there was no swag to be had, although did bring home a couple of vuvuzelas from the nice guys at Loud3R. No conference bag, fleece jacket or even a t-shirt and the only mention of the 20th anniversary was a small sign off to the side by the entrance. The conference has also become a hand me down, passed from Stewart Alsop to Chris Shipley and now to Matt Marshall. This year, for the first time, the conference was in Santa Clara (rather than the normal dessert resort location), close to home, so decided to attend.

My fears were met on Day 1 with many presentations being unpolished, several me-too ideas and a general malaise. To be fair, the Day 1 categories were primarily infrastructure companies (Enterprise, Cloud and Mobile). Day 2 featured the consumer and social media, which were more interesting for me and much of the audience.

Everyone tries to have a memorable demo, often with a musical number, quasi celebrity or skit. Didn't see YCombinator fans Ashton Kutcher and Demi Moore in the crowd, but one of the presenting companies, Integrate, a customer interaction platform in the enterprise category had co-founder Jeremy Bloom give the pitch (picture on left) Bloom is a former NFL football player, Olympic and World's #1 freestyle skier and star at the University of Colorado. I guess if you've run a pattern across the middle with Ray Lewis waiting to knock your head off, a 6 minute pitch in front of a bunch of geeks is a piece of cake. Didn't get the chance to ask him if managed to visit Berkeley while he was in town and see the 52-7 whupping that the Buff's took at the hands of Cal. Go Bears!!

Day 2 was much more interesting. Jeffrey Mullen of Card 2.0 was the opening act and ended up grabbing the $1M People's Choice award along with one of the five DemoGod awards. You can watch all of the presentations at the DEMO site and can see if you agree with my favorites:

Card 2.0 - A very cool credit card with a programmable magnetic stripe that requires a password entry on the card to show the full card number (for card not present transactions) and enable the card to be swiped at retail locations.

Bump - These guys got my vote for the People's Choice. Bump.com is a social network based on license plate numbers as the identifier. Imagine the satisfaction of sending a nastygram to the guy who just stole your parking space or texting that hottie you saw for a second at the traffic light. Ok, does enable a whole new way to stalk and lots of privacy issues. I got a chance to ride in the backseat of the car as it drove through the convention center parking lot and logged in license plates at 5 per second (see picture above)

Needly - A cross between Craigslist and Ebay - a better way to sell your stuff and services.

Scayl -A slick way to email huge files, including HD Video.

VoiceBase - Transcription and search of voice communications (presentations, conference calls, etc.)

TuneUp - iTunes plug-in that cleans up your music library.

FootFeed - The only Day 1 company on my list. A check-in aggregation platform. I'm anti check-in and have been a conscienious objector in the whole category. However, liked the team, and Dennis Mink, FootFeed's CEO, convinced me of the value in check-ins as a white label service for brands to market to their customers. They also gave an entertaining pitch, with biz dev guy Kemp Mullaney playing the role of a harried guy about to enter the 12-step Check-In program before discovering FootFeed.

Back to the question posed up top. After an enjoyable day 2, maybe DEMO still has some life. I'm not going to write off DEMO completely, but will be surprised if it makes it to 25.

Angie's List or AngelList?

2010-09-02T11:54:00.001-07:00

An excellent question to ponder as the school year begins, but the answer depends on whether you are looking for a plumber or an angel investor.

The fall semester at SJSU started this week and had the first class meeting of my Entrepreneurial Finance class, which was overflowing with students standing, sitting on the floor and begging to get in. I'd like to think that work of my excellent teaching has made it's way around campus or that the Entrepreneurial fervor has reached new heights, but I've seen my ratings on Rate My Professor. Still wondering who that student was loved the course, but said I was a dork with a voice like Steven Hawkins. More likely the reality is that many students are trying to fill that last elective to graduate, which has not been easy with all of the budget cuts resulting in fewer class offerings.

Many of my students are finance majors, so I spend the first class with a (very) brief corporate finance review with the hint that very little applies to start-up finance. In corporate finance, students are taught that capital markets are efficient and this is an underlying assumption for valuing stocks, bonds and other financial instruments. The theory states that all ifnormation is publicy available and it is not possible to earn returns above average on a risk-adjusted basis. Whether you buy this or not for public equities, the market for early stage private companies has always been wildly inefficient. Entrepreneurs struggle to find investors and investors struggle to find the best start-ups. When they do, it is often a competitive situation and the hot start-ups end up oversubscribed and instad of adjusting price and other terms to optimize the deal, they are forced to leave some interested parties out.

While VC firms have been easy to find from the old school days of Pratt's Guide to Venture Capital, to the early web presence of the 1990's and the current web sites, blogs, twitter feeds, facebook fan pages and sites such as The Funded, angels are still a bit harder to track down. We do have certain angels aggressively marketing themselves (Good to see my former student, Dave McClure, making a name for himself as part of the PayPal Mafia and "Super Angel" crowd), many others have no interest in publicizing their net worth or investing activities.

According to the Center for Venture Research at UNH, there are over 260,000 angel investors. How the hell are you going to find and ptich the one who is going to invest in your deal??? These angels invested $17.6 billion in 2009, which matches the amount invested by VC's. However, angels invested in 57,225 ventures vs. 2,795 for VC's. It goes without saying that a much higher percentage of the angels deals are seed than VC, so you are likely looking at a 1 in 50 shot of getting your company's initial funding from VC's vs. angels (if you are among those that are able to raise either!). And the 1 in 50 is a team that has already made that VC money. While the supply-demand equation will never be completely fixed, the information and accessibility to angel investors is only getting better.

There are several efforts being made to make this process better and will mention a couple below:

Angel Capital Association Collaboration Committee - I was a charter member of the this group and the goal is to facilitate syndication among the angel groups via education and tools such as Angelsoft. One of the issues in angel group investing is that any one group often doesn't have the investor interest level to provide the total capital required for a round. At Sand Hill Angels, our initial investments are in the $100 - $500K range and rounds are typically $500K - $1.5M. The goal of cooperation is theoretically very interesting, but practically difficult. There tends to be a strong groupthink mentality in the angel groups, and once one group has decided to invest, the others still need to run through their process, which can take weeks to months. This is a brutal process for entrepreneurs and many have no interest in the angel groups for this reason. At SHA, we have instituted a fast track process where companies that have already lined up committed investors (including some SHA members), can expedite the process. We recently led a financing for AppBistro, that had a great group of investors committed, including Dave McClure and Alfred Lin. I joined the board and am looking forward to working closely with the team.

The AngelList - a service where entrepreneurs can connect with angel investors an dangels can share interesting opportunities with other angels. I recently became aware of this list and just joined and have started reviewing some of the start-ups and looks like an excellent resource for both entrepenurs and investors. I'll follow-up in a future post on how it has worked for me.

Now back to the original question posed in the title. For angel funding, my choice would definitely be AngelList. Of course, if you are looking for a plumber, Angie's list would be better. However, you never know, you might find a start-up that has a cool mobile app to fix your leaky faucet...

Do you have a U.S. Strategy?

2010-07-02T15:51:00.000-07:00

Seems like an appropriate question to ask as we enter the 4th of July Holiday weekend. My wife's boss, Andy Grove, penned the cover article on the current issue of Business Week, "How Americ a Can Create Jobs". Andy argues against common wisdom here in Silicon Valley that start-ups are behind all new job creation. He points out that manufacturing employment in the U.S. computer industry is less than it was 35 years ago, while at the same time, a very effective manufacturing industry has emerged in Asia employing 1.5 million workers. A similar trend is happening in alternative energy, the industry that has greatly benefited from both venture capital and US government assistance over the past decade.

Never one to propose popular or easy plans, Andy suggests rebuilding our industrial infrastructure and employment through financial incentives and taxing products of offshore labor and using the proceeds to incent companies to scale their American operations. He believes that this transfer of manufacturing and engineering expertise out of the country will ultimately lead to less innovation.

When my wife first mentioned this Job Wars research project she was working on a few months ago, I responded with the traditional view that start-ups are the vehicle of job creation and government policy should be to not get in the way of this ecosystem, as New York Times Columnist Thomas Friedman argues in "Start-Ups, Not Bailouts." I sent her a bunch of data to refute these claims. According to the Venture Impact Study sponsored by the National Venture Capital Association ("NVCA"):

In 2008, Venture Backed companies employed more than 12 million people and generated nearly $3 trillion in revenue (11% of private sector employment and 21% of GDP)
Venture Backed Company Job Growth was 8x private sector job growth from 2006-08
In 2008, one U.S. job existed for every $37,702 of venture capital invested from 1970-2008

Let's assume these statistics are true (of course that may be a leap, as my wise father-in-law used to say, "Figures Lie and Liars figure"). This does show that venture backed companies have a huge impact on the US economy. However, it doesn't tell the rest of the story about how much larger these numbers might be without transferring a large portion of GDP overseas. As I think more about this, Andy may have a point.

Perhaps a discussion worth having at your beach parties and barbecues this weekend. Enjoy the fireworks!

Negotiating an Angel Deal in your PJ's

2010-04-01T11:15:00.001-07:00

Well, not exactly...I was part of a Dow Jones VentureWire webinar last week titled Negotiating An Angel Deal: What Angels, Entrepreneurs & VCs Need to Know. I prefer the traditional face to face where you can interact with the other panelists and audience, but was the first panel I did wearing my favorite flannel penguin pajamas...

It had a good mix of viewpoints with east (James Geshwiler, Common Angels) and west coast (yours truly) angels, early stage venture capitalist (Jason Mendelson, Foundry Group), and a couple of attorneys (Dan Hansen and Mario Rosati). It is obviously too late to dial-in to the call, but you can still order a CD of the session. If you don't want to spring for that or spend 90 minutes listening for that one nugget you are looking for, I'll share a few of the topics I found interesting.

Dumb Money - Are we as dumb as we look? One comment made by Jason was that angels tend to be less sensitive than VC's on valuation and can potentially make it difficult to get a venture financing done at acceptable valuation. While this may certainly be the case with unsophisticated angels (much less of these now) or in cases with no lead investor, I'd argue the opposite. We are typically looking at either smaller exits or require a lower valuation to get a reasonable step-up to a venture round. In my experience, venture investors are more focused on percentage ownership, which obviously requires a trade-off with the amount invested and valuation.

KISS - No, not one of the guys on the left. The old Keep It Simple Stupid Principle. I had a discussion with another angel investor a few months ago and he was bragging about the deal he just struck that included a 3X participating liquidation preference. I let him know that he just accomplished two things - left a bad taste with the entrepreneur and opened the door for the next investor to ask for a multiple preference that is senior to yours. While upstream investors can certainly ask for more in any financing (The Golden Rule), it will be much easier to get simple terms if the precedent has been set from the beginning.

A related topic is the standardization of terms. There has been a lot of discussion and publishing of standard term sheets, including Y Combinator, TechStars and SeriesSeed. A good comparison of the various "standard" term sheets can be found at Start-up Company Lawyer. Mario's firm, Wilson, Sonsini, even has a term sheet generator on their site. You answer a few questions and similar to TurboTax, out pops a term sheet instead of your tax return. Not quite as much fun to play with as the Dilbert Mission Statement Generator, but probably more useful. Consensus seemed to be that all of these "standard" terms are a bit different and while not possible to completely standardize (no company or financing is exactly the same), the guiding principle should be to keep it simple (see above) and minimize legal fees.

One other topic discussed was the recent legislation introduced by Sen. Dodd that could have a big impact on angel investing and job creation. A couple of items buried in the 1300 page bill include changing the definition of an accredited investor and moving regulatory roles on private3 placements from federal to stage level. This will both reduce the number of angel investors and make it more difficult to syndicate across stage lines. Lobbying is ongoing by both the National Venture Capital Association and Angel Capital Association and James Geshwiler on the panel wrote a recent post on the ramification.

I will be speaking on a related topic next week at an SVASE event in Palo Alto, "Founders vs. Investors - Are we all on the same page" Hope to see some of you there and promise I won't show up in my pajamas.

Would a Dart Board Provide better VC Returns?

2010-02-26T13:42:00.000-08:00

For those of you that are regular visitors at ProfessorVC, I apologize for the long hiatus over the holidays and beyond. I know there are at least a few of you as I received several emails this week along the lines of "no new posts since November???"

Well, I'm back. Was amused to read about Right Side Capital this week. They have raised a fund to provide seed funding of $50-$250K to 100-200 start-ups. Rather than going through their networks or targeting specific sectors for deal flow, they are going to rely on an algorithm to select companies. The formula will be based on the founders' experience, schools they attended and other background information to gauge the likelihood of success. This certainly gives new meaning to "drive by investing" which became popular in the late 90's....

My first reaction is incredulity that limited partners would buy into this idea. Of course, when 10-year returns for the entire venture capital asset class is about to drop below zero, drastic measures may be in order. Seed stage investing is all about the team, so there may be something to this idea. For firms that don't have access to the most successful entrepreneurs, trying to predict an individual or individual teams success rate based on experience, personal attributes, intellect, etc. might very well be a good way to find some promising first time entrepreneurs. This is not far from the Y Combinator model, except they put a lot of time and energy into working with the entrepreneurs. With 2 or 4 new investments per week that Right Side is projecting, it will be challenging enough to remember the names of the entrepreneurs in their portfolio, let along help build companies.

This got me thinking about the debate over serial entrepreneurs and whether success breeds success or complacency. My colleague, Anu Basu, Director of the Silicon Valley Center for Entrepreneurship at San Jose State, recently completed a paper on this topic, "Does Experience Matter? A Comparison Between Novice and Serial Entrepreneurs" Her research shows that there is a positive correlation between prior founding experience and new venture performance due to stronger and more diverse social networks, access to capital, reliance on collaborators and other factors.

While this is not surprising, it would be interesting to look at returns provided to venture capital firms from novice and serial entrepreneurs. Serial entrepreneurs would be more likely to have larger personal investment in the company, have taken outside investment at higher valuations and possibly less open to taking big "bet the company" type risks.

Of course, given the state of venture returns, perhaps randomly picking from a stack of business plans would provide as good or better results than an entrepreneur selection algorithm or detailed due diligence. I recall that the WSJ used to run a contest in stock picking between investment analysts and selection by darts. The random selection fared quite well against the analysts and now the contest has shifted to readers vs. darts. The darts seem to be doing quite well over the past few years...

Can Entrepreneurship Be Taught?

2009-11-19T16:34:00.000-08:00

I attended the annual LP meeting for a venture capital firm this week and got into a discussion about the above question. Seems like a good question to ponder given that I spend several hours each week as a professor of Entrepreneurship.

At a high level, I definitely agree that being an entrepreneur and being in school don't necessarily mix. Most of us know of Exhibits 1 (Bill Gates) and 2 (Mark Zuckerberg) from Harvard, but I have met dozens of other successful entrepreneurs who felt a greater need to get going on an opportunity than to wait around to complete a degree.

However, for most of the rest of us, the analytical skills honed in college or grad school, along with the opportunity to network and explore different fields prove invaluable later. With that in mind, I created a new course at San Jose State last year, the Entrepreneurship Lab (E-Lab). The seminar course combined an internship at a start-up or venture firm with classroom learning and sharing of experiences. There was an application and interview process to be admitted to the class so I was able to have a diverse group of students with varied educational and work backgrounds. Business, Engineering, Computer Science, and Design were all represented.

I'm teaching the class again this coming semester and held an information session for prospective students this week. I had several of the students from E-Lab I come to share their experience with those interested in applying for E-Lab II (went with the Super Bowl numbering scheme to see if I can convince the powers that be to make this a permanent part of the curriculum). I was blown away by some of the testimonials of how the course was a career and life altering experience for the students. I realized that opportunities like this are so rare and students don't get enough of this type of experiential education.

Here are a couple of quotes from the students:

"The internship provoked by thinking and challenged me to pursue my interests with more drive and determination. The opportunity provided by the [E-Lab] has been truly inspiring. And now I know exactly where I want to spend my time"

"This internship truly provide me an entry point into the private equity world. I am still not certain about exactly what I would like to do for the next 30 years, but I am certain that it will have something to do with funding/valuing/investing in start-up companies."

I think something else they liked was that there was no final exam, since in the real world, you are judged by the market and investors rather than on a grading curve...Instead, we spent the designated exam time with a final debriefing of the semester at Gordon Biersch brewpub (see below)

Special shout-out to Dan Gordon, founder of Gordon Biersch, who has been a great supporter of our entrepreneurship program at SJSU and is hosting my Entrepreneurial Finance class at the brewery next week.

If you are interested in getting involved in the E-Lab, there are a few opportunities. If you are an SJSU student, the priority application deadline is December 10 and you can find more information and an application here. If you are interested in hosting an intern, we will be accepting employer applications in December and January for internships beginning in February. If you are interested in sponsoring the course, would love to hear from you as being part of a state institution in California provides its own special challenges.

Now back to the question at hand. Entrepreneurship can be taught, but the jury is out on whether you can teach someone to be an entrepreneur. However, I've seen a number of students not find their entrepreneurial DNA until exposed to the content and guest speakers in the entrepreneurial program. That's enough to keep me teaching!

Watch Out for the Red W(h)ine

2009-10-20T14:47:00.000-07:00

I have been following the rallying cry of entrepreneurs with some amusement over the past couple of weeks in response to a blog post by Jason Calacanis, "Why Start-ups Shouldn't have to pay to pitch angel investors." In fact, I was cornered by a member of this camp at our recent Sand Hill Angels annual social event at the Wine Room in Palo Alto (great place, by the way). I was afraid if I didn't answer the question of whether Sand Hill charges entrepreneurs to pitch properly, I might be wearing a very nice pinot.

I've written about the practice of charging entrepreneurs in earlier blog posts and it is not something we would ever do at SHA. However, the individual above was adamant that we should have a PR campaign to let the entrepreneurial community know that we don't participate or support this practice. I laughed and said that our web site made this clear and we may have even put a brief posting to this effect on our twitter feed. I'm also a strong believer that your track record and reputation are your most valuable assets in the venture community. This is not something that can happen overnight by putting a press release on the wire.

However, this is a great question to ask at the front of the process. I have put together a list of questions to ask your angel investor group contact:

Do you charge any fees to present or during the due diligence process?
How many investments have you made this year? Last year? Average size?
How many of those investments are initial investments? Follow-on?
In how many of those were you a lead investor?
How many do you have a board seat?
What percentage of your members have made an investment in the past 12 months?
What percentage of your members are not active angel investors (i.e. service providers)?
Do you invest as a fund, single purpose entity or as individuals?

This is not a comprehensive list of questions, but certainly a good start? At Sand Hill, we are very active and often lead investor and Series A board representative. We made 12 investments last year (5 new and 7 follow-on) and are on the same pace in 2009.

For those who do charge, should you avoid them like the plague or burn at the stake? I wouldn't go that far, but certainly fair to determine what you are getting for your limited amount of cash. Here is a list of questions I'd ask:

How much is the fee?
When are we obligated to pay?
What do we get?
Are you a broker-dealer? (Note: Finders fees are illegal in California for non broker-dealers, not sure about other states)
Do you have any service provider members? Do you charge them a fee?
If you do charge, why are you you charging me for the privilege of being added to a telemarketing list? Shouldn't you be paying me?
How many companies have paid fees in the last year?
How many of these have received investment for your group?

I don't think it's time to hang all angel investors in effigy, but remember that due diligence goes two ways...

Survey says VC's invest on Gut Instinct

2009-09-24T13:04:00.000-07:00

Nope, the above quote isn't from Richard Dawson on Family Feud, but similar to a headline that caught my attention on the front page of the business section of the San Jose Mercury News this morning. Not that it was surprising, but that it would be news worthy of this placement. Once I got past the headline, I realized, that Scott Harris had the same reaction to the survey that I did.

He was citing a survey done by John Paglia at Pepperdine University. Harris writes "'Gut Feelings were cited by 67 percent of 185 venture capitalists surveyed, while [discounted] cash flow analysis was cited by 43 percent" as techniques used in analyzing potential investments. It struck me that the 43 percent number for DCF was really high, but if a sizable chunk of the VC's surveyed are late stage, would make more sense. Or perhaps, that is just my west coast bias to
think nobody pays attention to DCF.

I decided to go grab the survey to see if there was more. I pulled the report and buried in table 28 on page 35 is the data cited in the article. The data makes a lot more sense if you look at the entire table. I'd break down into two separate pieces - financial analysis and business/market analysis. On the financial analysis end, you have multiples far and away the most common valuation method over DCF, Simulation and Option analysis. I've never heard of a VC running Monte Carlo simulations on possible outcomes. Either the company is going to be successful, wildly successful or will fail....I always focus on the business model and assumptions, but there are too many unknowns to put much faith in the future cash flow projections.

On the other side, you have Market Analysis (96%) followed by gut (67%). This brings up the age old question on whether you are investing in markets or teams. If you've got a large growing market, solid team, strong competitive position and compelling solution, you'll move forward with diligence, which can range from going with your gut to doing detailed projections, numerous reference calls and deep market analysis.

Let's get back to the topic of gut investing. I was a limited partner in Angel Investors, LP, Ron Conway's fund in the late 1990's. They clearly went on gut and were often accused of drive-by investing, but that has to be the only way to invest in 200 companies over a 3-year period. Luckily, Ron's gut told him to get as much money as he could in to Google, which saved the fund.

I just finished reading Malcolm Gladwell's Blink.

Blink starts with the anecdote of the Getty Museum's $10 million acquisition of a rare Greek statue dating from the 6th century BC. They spent 14 months researching the authenticity. A geologist spent two days examining the statue with a high-resolution stereomicroscope and removed a sample and "analyzed it using an electron microscope, electron microprobe, mass spectometry, X-ray diffraction, and X-ray fluorescence." The conclusion was that it was indeed old.

However, when several experts in Greek sculpture viewed the sculpture, they were all able to see immediately that that it didn't seem right, but couldn't necessarily articulate why. Turns out they were right and the statue was fake. Whether this was gut, natural intuition, or some other subconscious analysis from years in the field, it doesn't matter. The point is their opinions weren't clouded by any vested interest or lengthy analysis.

Certainly, a corollary to VC's who have seen hundreds or thousands of start-ups and can often tell within the first 2 minutes or 2 seconds whether an investment is even a possibility.

Back to the survey. One other chart worth noting is the the expected returns from various private capital providers (Banks, Asset based lenders, Mezzanine, Private Equity and VC). From the chart to the left, you can see that the 42% expected return of VC is clearly an outlier on the graph.

Of course, if you look at the Cambridge Associates data ( graph at the bottom left) comparing venture capital returns of top quartile vs. median funds, you'll see that over the past three decades, the median fund has never returned over 40% and that the returns have been 0% over the past ten years. In looking at that data, if I'm a VC and promising LP's a 42% return, my "gut" might be telling me to to find another job when the fund is done.

Burn Rate

2009-07-22T11:07:00.000-07:00

The burn rates of my portfolio companies is certainly top of mind right now, but that's not what this post is about. Not yet anyway...Things may change by the end.

Ever wonder what your ops guy is doing when he's not obsessing over your site's health 7x24. If anyone still carries a beeper these days, it's him. Well, our VP Operations at Fliqz, Daniel Marcus, dabbles in creating writing and music when not managing our data center.

His specialty is short fiction of the sci-fi variety, but has also authored numerous papers in the areas of applied math and computational physics, if that's your thing. Since I'm not a fan of any of those genres, I have been looking forward to the release of his latest work, Burn Rate.

A quick synopsis from the book jacket blurb:

Ross and Lori Williamson are living the Boomer version of the American Dream. Ross is a Silicon Valley entrepreneur, battered but still standing after the Internet collapse. Lori has quit her upscale corporate law job to make pottery, study martial arts, and start a family. Unable to conceive, they hire Annie Day as a surrogate to bear their fertilized egg to term. Annie has a few skeletons in her closet, including an ex-boyfriend desperate for cash and on the run from the Italian and Russian mobs.

It is hard to tell the bigger villain - Microsoft (aka evil empire), the vulture capitalists (aka Sand Hill Road) or the Jewish kid from Brooklyn who after some problems with gambling (what kind of nut bets on the Knicks?) and drug dealing (to pay off the stupid bet) takes up kidnapping and murder. Once you get past the stereotypes (of the first two anyway), this is a very funny and entertaining read and a great page turner to take to the beach or pool on one of these hot summer days.

While there are certainly better books that chronicle the highs and lows of starting a company, Burn Rate does raise some interesting issues on the personal side of entrepreneurship. The protagonist, Ross Williamson, is struggling to finance his company and hang on to his team during the process. His angel investors are tapped out and the VC's aren't biting. He convinces his wife to let him take a second mortgage on their home to give Tesseract a few more months of runway.

While credit cards, second mortgages, and personal guarantees are all common methods of early stage funding, they can certainly put a strain on marriages and personal relationships. When he receives a lowball acquisition offer, he must decide between protecting his hide and leaving his team hanging or rejecting the offer and rolling the dice on a better outcome.

I won't spoil the end of the story, but wouldn't bet against the good guys....Now back to hunkering down and figuring out how to deal with the burn rates in the portfolio.

Can you start a company on $10K?

2009-05-30T11:09:00.000-07:00

Nope, not another post on boostrapping, although certainly a big part of this question. We held our annual business plan competition at San Jose State this month and first prize was $10,000. While difficult to do a lot with, there are a number of non-pecuniary benefits in addition to the cash.

First prize went to one of my students, Ryan Guerrettaz (giving the winning pitch below), for his college notes sharing service, Rate-the-Test. I think it's a great idea, although one of colleagues starting calling it Cheating.com and StealtheTest.com. One way to look at it is to level the playing field for those students not in fraternities where old (and probably sometimes current) exams are in the filing cabinet.

This is a much bigger idea than that and is really about helping students succeed. Particularly at a school like SJSU, where a large percentage of students are working part or full-time while taking a partial or full load of classes, time is a precious commodity. As a professor, I would also be very open to loading my materials to a site like this both to help students and to share with entrepreneurship faculty at other universities.

Ryan was actually working on another business plan for my class when he came to discuss this concept with me a few weeks before the business plan competition. He was concerned that he wouldn't have enough time to do a good job on the business plan in such a short time and asked me to advise him on whether to proceed. As a part-time academic, I had to pontificate and give him the scholarly answer, which was "Why the Hell Not??". He worked over 50 hours the final three days, saw his girlfriend once in three weeks and blew off other activities, but beat the midnight deadline by a few minutes.

Rate-the-Test was selected for the semi-finals, which gave him a couple of days to prepare a pitch deck. He did an adequate job presenting and barely made it to the final round. However, this gave him a full week (or 30% of the time already spent) to focus on the presentation and feedback from the semi-final judges. By the morning of the finals, he was ready, gave an excellent presentation, and responded to the judges questions with well thought answers.

Back to the question at hand. Certainly, starting a company on $10K is not easy, but it can provide a great start and the motivation to move ahead. In addition to the first prize, he was also given office space at the Plug and Play incubator for the summer and get to spend his days with other entrepreneurs and investors.

However, it will be under a different name as it may be hard to get profs to cooperate with a site called Rate-the-Test and the service will offer much more than previous exams. I look forward to seeing my students using this service in the fall semester. Also, if it turns out he neglected his girlfriend too much while starting up the company, he'll certainly have the opportunity to meet plenty of co-eds as he hands out flyers for the site on campus. With $10K, certainly can't have a marketing budget to do anything but guerrilla marketing.

Bootstrapping 101

2009-03-10T11:41:00.000-07:00

I moderated a panel discussion last night on one of my favorite topics, bootstrapping, as part of our Silicon Valley Center for Entrepreneurship Eminent Speaker Series at San Jose State. One of my colleagues, Joel West, beat me to the punch with a summary of the program.

We had a good mix of experts on the subject:

Jon Fisher, serial entrepreneur, blogger and author of Strategic Entrepreneurism
Gustavo Alberelli, director of Kennet Venture Partners that specializes in investing in bootstrap companies
Ilya Ronin, a former software engineer and SJSU alumnus who is one of the three executives of bootstrapping Marpo Kinetics (an exercise machine company)

Gus shared the strategy of Kennet, which is a unique breed of venture firm, sitting in between early stage Sand Hill Road VC's and late stage/private equity players. They have a standard presentation on bootstrapping, which they present around the country. Kennet has a white paper on that summarizes why bootstrapped businesses are the best. Another interesting related point that he made was that only in Silicon Valley does this message seem to fall on deaf ears, although maybe not now! In other parts of the country, this is business as usual:

Identify a customer need
Build a product
Sell the product

In the valley, the knee jerk reaction is to start with the powerpoint deck and look for the venture capital drug....

Jon Fisher purposely avoided raising venture capital in his ventures. His latest venture, Bharosa, was sold to Oracle for a 6X multiple in 3 years to his angel investors, a sweet close to triple digit IRR. His goal in building the company was to spend 3 years building value and find a good home for the engineers and product. In this case, a win-win for everyone, except perhaps the VCs who didn't get the opportunity to participate. Certainly not to say they couldn't have raised more cash and built this in to a bigger company, but was nice to have the option of going either way and doing what was right for the founders and employees.

Finally, Ilya Ronin, shared the Marpo Kinetics story, a true bootstrapped garage start-up. The three founders shared a vision, built the exercise machines in the garage, and knocked on doors at health clubs, attended trade shows, and worked the phone to get initial sales. We don't know the end of the story, but they have built a real business with hundres of machines sold to gyms all over the world along with government contracts for military purchases.

In this economy, all entrepreneurs are going to hear a lot of "no's", but time spent going after customers rather than investors should provide a higher return on investment. Of course, assuming you are successful in the first, the latter will certainly be an option in the future.

The Most Important Venture Capital Statistic

2009-01-20T07:33:00.000-08:00

A couple of headlines caught my eye in this morning's VentureWire:

Deals Slow As VC Feels Economic Chill
Web Video Platform Fliqz Gains $6M In Series C Funding

The funding news and general condition of the economy has been no secret and certainly wasn't a surprise that venture funding in the fourth quarter was the lowest level in four years and most expect the decline to continue at least through the end of 2009. The latest statistics from VentureSource show 554 financings in Q4, down from 620 in Q3 and 718 in Q4 2007. Total amount raised fell from $7.5 billion to $5.5 billion quarter over quarter. First round median investment size fell to $3.8 million and $4.2 million for the year, which is the first time it has been below $5 million since 2001, a sign that capital efficiency will be even more important than it has.

Of course, the most important funding statistic to an entrepreneur relates to one specific company, and whether there is sufficient capital available to build and scale his business. On that front, I take pride in the second headline with news that Fliqz, where I am CFO, just closed on $6 million in Series C financing. From first hand experience, we certainly felt the market conditions and the funding process was much more difficult than anticipated.

I'll share a few points about how we were successful, but most of the credit goes to Benjamin Wayne, founder and CEO of Fliqz, a passionate, strategic and tactical executive. The funding search began the day after Labor Day and continued throughout the fall as the environment continued to worsen, and resulted in a term sheet the day before Thanksgiving.

Here are a few takeaways from the process:

Extend Runway - As we planned out our investment process last spring, we realized that there were still a number of areas we needed more proof points and the optimal time to raise capital might not be for another 2-3 quarters. We decided to raise some venture debt as an insurance policy and extend our cash runway. We drew $1.5 million from Lighthouse Capital Partners, which ultimately became critical to our balance sheet and they turned out to be a great partner as we worked through the equity financing process.

Evaluate Business and Financing Needs - We initially went out seeking $10 million in financing, but listened to the prospective investors and watched the market. Mid-way through the process, we took another cut at our business plan and built a model where $5 million would be sufficient to get us beyond breakeven. This brought in a new set of prospective investors and required a lower investment from the lead investor as our existing investors were committed and on board.

Don't miss Plan - This may seem obvious, but I've seen a number of CEO's shot for missing the first quarter's numbers after going public, which is a great way to shrink your market cap well before the lock-up period is up. Same principle here. Prospective investors have a free look to see how you execute under the gun. At Fliqz, we met or exceeded the sales plan every month during the due diligence process.

Look beyond the usual suspects - With Mohr Davidow Ventures, one of the premier Sand Hill Road firms already in the company, it would have been easy to focus on a short list of other top tier firms with long track records in the valley. However, as we soon discovered, many of these firms were forced to hoard capital for existing portfolio companies and focus most of their time and energy on deciding which ones deserved these reserves. Some were also dealing with issues of limited partners struggles with capital calls and asset allocations. With that in mind, new funds are a great place to focus. Without all of the legacy issues, they have the capital and time to seek, evaluate and actively work on new opportunities. Our lead investor, Triangle Peak Partners closed on a $170 million first fund in late 2008.

Of course, timing and luck are still a big part of a successful capital campaign, particularly with these market conditions. Many companies that have raised capital are going to need to spend it wisely to win and others will be forced to bootstrap.

Speaking of bootstrapping, this is always a subject near and dear to my heart and I'll be moderating a panel on the topic on March 9th as part of our eminent speaker series at the Silicon Valley Center for Entrepreneurship. More on that in a future post.

Why didn't I think of that??

2008-12-18T09:08:00.000-08:00

Great ideas can come from many places. Some result from years of work and/or education while others are a result of trying to identify a unique solution to a consumer or business problem. Of course, there are those that are completely ridiculous (think Pet Rock). We recently had our Neat Ideas Fair, which is my favorite annual event of our Silicon Valley Center for Entrepreneurship at SJSU.

The NIF (in it's 5th year), is essentially a science fair for entrepreneurs. A science fair conjures images of excited middle school kids standing in front of their poster boards explaining which type of paper decomposes the fastest or in my daughter's case, the longevity of chewing gum flavor. Not sure whether she was truly interested in the answer or just thought it was a great way to get her parents to buy her a big stack of gum.

Many entrepreneurial programs feature a business plan competition, which is a great exercise. At SJSU, we also have a business plan competition in the spring, which ideally allows the students to build a viable business model around their NIF projects. However, the NIF forces the students to focus on their idea and ability to communicate it's need, kind of like the Demo conference is all about the product.

The NIF brings together students from all parts of the university (business, computer science, mechanical engineering, design, life science, etc.) to share their passions and projects. Some have developed working prototypes, while others are still at the concept stage and only on posterboard. I really enjoy the collaboration among students in different parts of the university and the excitement of talking about their ideas and thinking through the business potential, particularly for the non-business students.

One of my favorite projects from 2007 was a solar power wetsuit. This was a collaboration between students in industrial design, electrical engineering and business. This team had a working prototype of the first solar powered wetsuit using nano-solar technology. They had done a lot of research talking with surfers and divers, as well as working with O'Neill, one of the leading wetsuit design and maufacturers.

Some of the most popular projects from this year's NIF were:

I.C.E. - Solar thermal collector that functions as an ince generator to provide cooling through a building
Tenebra - device with cryptological communication protocol that revolves around a cheap hardware random number generator to enable consumers and businesses to communication with military-grade protection
Snack Caddy - Reusable tray for carrying snacks and drinks at the movies or other events

You can see a description of these and other projects at the NIF site.

Here are a few of the budding entrepreneurs that I chatted with at the event:

Jeff Gibboney, a graduate mechanical engineering student, developed a battery operated skateboard for cruising to school or work. This new mode of transportation included a go-kart wheel, a motor and battery pack from an electric scooter, and sensors from a Nintendo Wii.

Manija Ansari is an undergraduate business student (currently in my Entrepreneurial Finance course), working on a social entreprenurial venture. She has developed a new twist on the micro-lending concept. Unforgettable treasures will provide micro-loans to third world crafts artists to enable them to build their business and will also market their wares through the Internet. She is planning on starting the business upon graduation.

There were a number of green projects at the NIF, including environmental studies major Alan Hackler's Zero Waste Solutions. Alan's concept is a foot pedal operated sink (to save water) that automatically separates compostable and other waste. While many people would have a hard time doing without a garbage disposal some municipalities have banned the use due to the impact to the water treatment systems.

Man Camp

2008-11-13T12:00:00.001-08:00

Just returned from a golf trip to Bandon Dunes, Oregon. We played a Ryder Cup style tournament with 16 guys (the motley crew to your left) over 3 days and 72 holes, with a few drinks mixed in. Waking up Monday morning with a golf hangover, I remembered I hadn't had time to prepare for my class that afternoon. This got me thinking about the business model that Mike Keiser has built at the resort and a lecture began to form in my head.

One of the guys on the trip referred to Bandon as Man Camp. If you haven't been, it is difficult to describe the allure. The location is remote (a 3-hour drive from Eugene and over 4 from Portland, with not much in between). Mike Keiser (the founder of Recycled Paper Greetings) had a vision to create a true links experience in the US.

As described by Stepen Goodwin on the book jacket to Dream Golf, The Making of Bandon Dunes, "Bandon Dunes would be a 'pure' golf experience, pitting the golfer against the elements, allowing the land to dictate the course, banning the use of carts, making the golfer feel as one with both nature and the game. To achieve that goal would take a great amount of planning and hard work, the struggle of man against nature in shaping the land into three courses that would become the Bandon Dunes complex. Convention wisdom said it was impossible. And even if he built it, would anyone come to this remote Oregon outpost?" Well, built it he did and they have come. Less than 10 years from the opening of the first course, the $150 million investment has been recovered. And the courses are all ranked in the Top 25 courses open to the public by Golf Digest, with Pacific Dunes (#2), Bandon Dunes (#7) and Bandon Trails (#21).

So what is about the business model that is so successful:

Focus on your core target market - The original marketing plan for Bandon Dunes is as simple as they come - "Great golf + great food + great people = marketing plan". They have done a great job of serving the market. Although I've seen a few brave women, the resort is full of middle to upper income middle aged guys who love serious golf. The offering is all about golf and camraderie - get there, stay on site, traditional golf, multiple courses, excellent pub food, and of course, the Bunker Bar (complete with poker, pool, stogies, and a bartender that will stay as long as necessary). No spa..yet, but I hear one may be in the plans. A gift shop with nice jewelry is adjacent to the front desk so you don't forget that important purchase prior to checking out, to help with the permission for the next visit. This is not surprising from a greeting card guy, who realized that $5 is expensive for a Valentine's Day card, but incredibly cheap compared to the price if not purchased...

Manage seasonal demand through pricing - Weather on the Oregon coast can range from gorgeous to downright nasty and can change from one of the other in a matter of minutes. While pricing never approaches Pebble Beach, it can be very expensive during peak season and more difficult to justify to the spouse at home. Both trips I've made have been in early November when prices are reduced by 50%. For the true golf fanatics, the second round of the day is half-price all year and the third is free. Also, if the weather gets really bad, they offer a full refund voucher good for your next trip - all about customer retention.

Grow organically - It took ten years of planning to get the first course open and nobody had any idea how many golfers would come. Once the first course opened, ground was broken on the second (Pacific Dunes). Several years later, Bandon Trails opened in 1995 and the fourth course (Old Macdonald) is scheduled to open by summer 2010. Certainly there must be a temptation given the success to grow faster or target other segments, but Keiser is committed to staying true to the vision, and making sure everyone can get in 36 holes in a day.I can't wait to go back, which is clearly goal #1 in the list of critical success factors if anyone is still following the business model tangent.

I'll leave you with the 11th hole at Pacific Dunes and a link to Dream Golf if you are interested in more of the Bandon Dunes story:

CFO's - More Guardian, Less Angel?

2008-09-26T15:48:00.000-07:00

Just received this month's issue of CFO Magazine (yes, I know, it should be a very exciting weekend) and found an article I was interviewed for a couple of months ago. The article, "More Guardian, Less Angel" discusses how CFO's add value to angel groups by helping to kill deals. I spent most of the time with the reporter talking about Sand Hill Angels and how we add value to the start-ups and entrepreneurs that we partner with, which is why I just have a small mention in the article.

It is certainly true that we can pick apart the financial projections or pour through contracts, legal and financial diligence, but none of those areas tend to be the most important areas in deciding whether to make an early stage investment. No company's future ever matches their projections and it is the assumptions and how the entrepreneur understands the market and sees the opportunity evolving that we care about.

As I am quoted in the article, it is easy to pick holes in a business plan. It is certainly good to take an analytical approach to any investment opportunity and many venture capital firms and angel groups do an excellent job of diligence. However, at the end of the day, your gut can tell you a lot more about whether to make an investment or not. How passionate are the entrepreneurs about their business? Can they recruit and get others excited? Do I believe they can succeed? Does the business model pass the smell test?

While no real data exists on returns in angel groups vs. individual angels, I often wonder which is the better way to invest. I enjoy my colleagues at Sand Hill Angels and like investing as a group as it enables us to lead investments, take board seats and have more influence. The downside is the groupthink mentality, which can work in both directions, killing deals and also creating a bandwagon effect. In a lot of our deals, there is often a tipping point where the deal will either move forward or die.

Even though I am an active member of an angel group, I often advise entrepreneurs that they may be better off raising money from individual angels rather than groups. A lot is based on how much money they are raising, terms being sought, entrepreneur's experience, stage and total funding required for the business. I'm going to do some more thinking on this topic and write another post sometime in the near future.