I wanted to talk a bit about the liquidation preference. I recently received a distribution from one of my investments that did not succeed.  The company was struggling, was out of cash, and took an opportunity to sell out at a fairly low price. The price was much less than the total capital they had raised. I got some money back, not all of my capital but at least some of it. Many other investors in the company got nothing.

The distribution of funds was dictated by a key right that that was attached to my preferred stock, the liquidation preference. This is the most common, and in many ways most important, right that comes with preferred stock. Investors insist on it. The liquidation preference is very important to protect the investors’ capital. Any entrepreneur needs to understand this term and how it works if they are meeting with investors.

The fact is that in this weak economy, more start-ups are failing. Many of those that do not fail are being forced to do down rounds. When a start-up fails, often there is some money that becomes available depending on the liquidation process – an acquisition or asset-sale will usually generate some cash. First to get paid are the lawyers who did the deal, then any debt holders. If there is additional money available, it goes to holders of preferred stock with a liquidation preference. Then, only after they have been fully repaid the original investment amount (or another amount that is negotiated), remaining funds may be available to non-preferred shareholders.

When companies raise multiple funding rounds over time, it is not unusual to actually build up a hierarchy of preferred stock holders. Each later investor might get priority treatment over the prior investors, or what is called a senior liquidation preference. So if a company raised three rounds of money, let’s call them the A, B, and C rounds, then the company may have four separate classes of stock, common shares and three different classes of preferred shares. If senior liquidation preference rights are present, then the series C preferred stockholders take priority over B, who take priority over A, who take priority over the common shareholders. Each class is entitled to get their original investment dollars back before anyone else can get any of the cash.

Let’s look at a simple example:

1. Founders start a company called New Corp and put in their life savings to get it off the ground. They hold common shares.
2. Investors put 1 million dollars into the company in a series A round. They get series A preferred stock with a liquidation preference over the common shareholders. Sorry, founders.
3. Later, additional investors put 2 million more dollars into the company. They get series B preferred stock with a senior liquidation preference over the series A holders.
4. And some time later, new investors put 5 million dollars into the company and get series C preferred stock with a senior liquidation preference over the series B and A preferred shareholders.

New Corp struggles and burns through cash. The CEO the series C investors brought in likes to fly first class and lavishly decorate his office. New Corp eventually get rid of the CEO but has run out of money and is unable to raise additional capital because the market and economy have soured. Nobody is buying their products anymore. They are approached by a larger competitor and presented with an opportunity to sell the company for 4 million dollars, which will ensure the remaining employees can keep their jobs and the existing customers will be supported. The board decides to take the deal.
It is a better option than shutting the doors.

Where does the 4 million dollars in proceeds go? After the lawyers are paid and any outstanding debt holders are paid, the remainder goes to the series C preferred stock holders. The B, A, and common stockholders get nothing. The senior liquidation preference ensures that the series C stockholders will be entitled to get their full 5 million dollars back (assuming a 1x liquidation preference) before any of the other stockholders get anything. In this case, the series C stockholders will get up to 80% of their money back, but everyone else, including the founders, will lose all their money.

Not all financing’s involve senior liquidation preferences. Sometimes all preferred stockholders share that preference on an equal basis. It is one item to be negotiated and in some ways will be driven by the terms of whatever the last investment round was. Once a precedent gets set, it is likely to continue into all funding rounds. Therefore terms in early financing’s turn out to be very important in setting the tone for later rounds.

This has covered the basics of the liquidation preference, but there are many scenarios and configurations. Sometimes investors can be entitled to take out more than they put in. Sometimes they can be entitled to be paid dividends. “Participating preferred” terms mean not only does the investor get their money first, but is then entitled to their share of leftover funds as if they were a common shareholder too (“double dipping”). Amounts can also be capped.

The situation points out the risks to earlier investors, especially angel investors, who tend to lose control over their investments when later rounds are done. They get pushed down the stack. The founders, unfortunately, never win unless the company succeeds. That is usually what investors insist on. The founders need to be motivated.

I was lucky in my investment. I participated in the last funding round, had a senior liquidation preference, and when the company was sold off I got about half my money back. I would like to think I was really smart but the fact is the terms were negotiated before I got involved. And, unfortunately, the company did not make it, which is never a good outcome.

In reality, the majority of companies experience some sort of exit event that is not ideal. Liquidation preferences play a very important role in these cases. It can even play a role in “good exits” in that it can direct outsize proceeds to preferred stockholders, or create funny incentives when the investors are entitled to receive identical payouts under different scenarios that treat common shareholders unequally. Founders and investors need to clearly understand these terms and work through what happens in various scenarios.

This has been a basic overview of the liquidation preference. For more information, I suggest some follow-on links, which include sample text, examples and language from actual deals.

http://www.burningdoor.com/askthewizard/2007/04/venture_terms_liquidation_pref.html
http://www.feld.com/wp/archives/2005/01/term-sheet-liquidation-preference.html
http://www.altgate.com/blog/2008/05/how-liquidation.html

Many people think of entrepreneurship within the typical stereotype or pattern of having an idea and building a successful business out of it. This pattern assumes entrepreneurship is about success. In reality entrepreneurship is about failure at least as much as success – at least it is for most people. And although ideas are important, ideas do not really strike me at the centerpiece of entrepreneurship either. The fact is ideas are a dime a dozen. Most ideas are meaningless without execution. Founders I meet with are always worried somebody will steal their “idea” but in reality this just isn’t practical. The idea is just a small part. So this definition does not work for me.

In my mind, the meaning of entrepreneurship is about four key concepts they don’t teach in college.

Action. Entrepreneurship requires constant action. When you take a class, or work at a regular job, generally people tell you what you need to do and when. Your job is to carry out those instructions in the most competent manner possible, until 5 or 6pm, then go home. The only exception to this rule might be the few most senior executives of a larger company. When you run a start-up business, nobody tells you what you need to do or when to do it. You must constantly be taking action to get a customer, develop a relationship, build your product, or pay your bills. Which action to take next, and how much effort or money to expend on it, whether you think you can go home now or not, it is all up to you. If you do not take action, you fail. If you take the wrong actions, you fail. The requirement for constant action with the real threat of failure looming over your head is a hallmark of entrepreneurship. Fortunately, most people work actually better under pressure.

Risk. Clearly, starting businesses is about risk, and especially the risk/reward trade-off that comes with creating something of value. But the risk I think about is not just the glamorous kind that comes with making a big bet and taking a shot at a payoff. It is about the everyday risk, like not knowing how you will pay you team next week, or if months of development will be wasted because user reject your product - and you have to lay-off half your staff. It is about walking into a big corporate client to negotiate a deal that will make or break your company, and having absolutely no idea what you are doing or how you will fulfill the promises you are making. It is about the real risk of going out of business, screwing up your customer’s business, letting your partners down, or losing your parents money. Risk, and the fear that always follows it, goes hand in hand with entrepreneurship.

Emotion. The emotional ups and downs of entrepreneurship are extreme. Start-up companies are a magnifier for emotion. They pack incredible highs and incredible lows into a very small window of time. Your emotions change from week to week, and even from day to day. One day you have an incredible breakthrough with your product, and prove you can do something you thought was impossible. Pop the champagne and call the investors. The next day you discover your great product idea has already been built by three well-funded venture backed companies, and months of work are wasted… and more importantly, precious time and capital has been used up. When we were trying to sell our first start-up, we knew that we would either a) be bankrupt and out of work in less than 30 days, or b) be the best return for our investors in years. We sold the company. But we couldn’t fly home for two more days because our discounted tickets required a Saturday night stay over.

Commitment. To see something through that is difficult, emotionally taxing, with huge stakes requires a high degree of commitment. When the chips are down, you need to put a smile on your face and move on. Don’t let the team sense your fear. Convince your customers you have the best solutions and then commit to see it through to the end and ensure they are delighted (or at least satisfied). Be committed to your team members, do everything you can for them and don’t jerk them around. Earn their loyalty by setting the right example. Respect them, don’t use them. Don’t hire somebody who you might have to lay-off in a few months - instead work a little harder.  Be prudent with your in-laws’ retirement fund, and if things go south, ensure you can live with yourself knowing you did every possible thing you could to make good on their investment. When it does blow up, commit to see it through, professionally, responsibly, all the way to closure for your employees, your customers, and your investors. And if you are fortunate enough to sell your company, commit fully to the buyer to see it through and make it a success.

Entrepreneurship is about taking a path others are not taking and not knowing what is around the corner. Entrepreneurship can sometimes mean loneliness, especially for the CEO who cannot share his fears and the true reality with those that work for him. But it is also about not being scared by all the things you don’t know, it about trying to create something when you don’t know if it is possible. It is definitely about making it up as you go along. And it is absolutely about intensity, passion, and fortunately, fun. The most rewarding things in life are never the easiest, and that is definitely what entrepreneurship is about.

Section 409A of the revenue code was enacted following the events at Worldcom, Enron, etc when executives ran away with millions by playing games with deferred compensation. Now section 409A of the code covers deferred compensation and most importantly for startups now sets rules regarding what is required to establish fair market value of stock options – rendering prior “rules of thumb” useless. Doing an appropriate valuation when issuing stock options will create an important presumption that the valuation of the stock reflects the fair market value and put the burden on the IRS to prove otherwise.

Larger startups will normally have an independent valuation specialist do 409A valuations, but seed stage startups such as I often work with need to do most of this internally as a practical matter: they have no money. Needless to say, company founders are not always excited by the final number, especially in this market. They often ask why the value of their company is not higher – especially in light of my prior post on valuing software startups for angel investors. I wanted to talk about these two critical valuation processes and provide some insight into why 409A valuations for early stage companies will often be a lot lower than valuations that are proposed to investors.

It might be easiest to first talk about the times when the numbers should be exactly the same. The total value of your company from a 409A valuation perspective and from an investment perspective should be the same whenever an investment is about to occur or has just occurred. This makes sense. If an independent investor agrees to put money into your company at a certain valuation, then by default you have established an independent value for your company. Therefore that valuation can be used to both derive the price-per-share of the investment, and can be used to derive an exercise price-per-share for stock options granted at approximately the same time.

The only thing to realize is that investors usually (but not always) buy preferred stock, while stock options typically cover common stock. This means that although the company valuation is defined, the actual market value will vary between the preferred stock, which has specific extra rights and is therefore more valuable, compared to the common shares, which are less valuable – especially once the preferred class is created. The key point is that when an investment occurs, that is usually a good time to issue stock options as well because a clear, independent value for the company has been established by the new investors.

A valuation challenge occurs however when you want to issue options but there is no active investment process underway. Without an independent investor agreeing to a value of your company for investment purposes, you need to compute a valuation using other methods. Methods can include one or more of a) calculating the value based on comparable companies in the market, b) calculating the value based on expected future profits and cash flows, and c) calculating the value by computing the replacement value of the company’s assets, usually software in my case. These methods produce a baseline valuation for the company that be used to set exercise prices for stock options.

However, the valuation produced by these methods for an early stage company tends to be a lot lower than the number you would include in a proposal for prospective investors. This really bothers some entrepreneurs: “Why are you saying my company is only worth X when you also state that we should be able to propose a valuation of 3 times X for investors when we are ready to raise money?”

The reason the numbers are different is that most valuations proposed to investors are bogus when it comes to the true value of your company.

A typical angel investor will look at dozens of deals before investing in one, and stats show that on the order of 3% of companies actually get funded by angels. That means that 97% of companies that are presented do not actually get funded, and therefore the valuation proposed for those 97% of companies is completely unrealistic – the company was clearly not worth the valuation being requested. Even those that do get funded often go through a process whereby the valuation is negotiated downward. This means that the valuation proposed to investors is almost always an “optimistic” valuation, one based on a built-in assumption (and a false one) that your company is worthy of being funded. Only 3% of companies will be so fortunate and even then the valuation will be further negotiated.

So without finding an independent investor who agrees to or negotiates a valuation, the optimistic or proposed investment valuation is not the true value of your company. In practice it would be wrong over 97% of the time.  Therefore the true value of your company is most likely a lot less than you would propose to investors. And the various valuation methods I talked about above help us make a good guess at what that true valuation might be. In some simple cases, it boils down to calculating how much you have spent developing your product so far, making a few adjustments, and basing the whole valuation on that result. The logic is that any other company that wanted what you have would need to spend a similar amount of money, therefore for a pre-revenue software company, this calculation can give you a pretty good idea of what the value of your company is for 409A purposes. This is heavily simplified so you should always work with a board member or other advisor to perform valuation calculations and document them appropriately.

One final point I want to discuss is that in this market, especially for later stage startups that have made a large investment in building product, the company can actually be worth a lot less to investors than the total prior cash investment. For semiconductor companies right now, there are a lot of “down rounds” happening. This means a new investment is happening at a lower valuation than the last one. Often the new valuation is less than the total funds invested into the company in the past - the company has lost significant value. Down rounds are never pleasant for anyone – founders can be significantly diluted, early investors can be “crammed down” by new investors, prior investors may have to put in more money to maintain preferred share status, and the like. Sometimes shuttering the business can actually be easier. I only point this out because in some cases looking at the asset value of your company can produce a number much higher, rather than lower, than it would actually be worth to investors.

In the end valuing your startup is not a straightforward science. However it is critically important to do an appropriate valuation when you want to issue stock options. Issuing stock options with an exercise price that is below fair market value triggers tax liability for the recipient and could lead to under-withholding by the company from a payroll perspective. And now with section 409A of the code enacted, issuing stock options with an inappropriate exercise price can trigger additional penalties of 20% of more. Therefore it is critical to find an experienced advisor to help you when you are ready to issue stock options to key employees, consultants, and service providers. Stock options are one of the most exciting upsides to working in a start-up – the last thing you want to do is mess them up so the recipient ends up paying extra taxes and penalties to the IRS.

The first key question I want to answer is “Are these programs working?” Many of the programs are new, so there is limited operating history and many are not transparent. To evaluate success, I needed to select an older program that would have some investment history. The three I looked at were YCombinator, TechStars, and Digital Assets Deployment (DAD). There programs were all started in 2005-2006 and are generally transparent with their portfolios. In the end I chose YCombinator which is the oldest and has the largest available investment history.

There is a risk that in choosing one program, especially the earliest and best known, the results will be skewed. However, my position is that if one or more of the programs work, then the “model” works, and just like in any business category, in practice some will execute better than others. For comparison, historically, the VC model “works” but in reality dramatic returns are seen primarily by the so-called golden circle of top firms and not all firms make money for their investors.

I also decided to limit my analysis to YCombinator investments in the years 2005-2007, as these have the most available history and thus potential for exits. Looking at approximately 60 companies over those 3 years, and making some educated guesses along the way, the summary data looks like this:

Making several more less-educated guesses, I did my best to estimate yearly portfolio performance so far, and the future potential given the number of companies remaining in the each portfolio that have received further funding:

Based on this data, and depending on actual non-investment program expenses, it seems very likely YCombinator has been net profitable so far, though probably not dramatically so. Looking forward there is still tremendous potential in the portfolio.

YCombinator had a successful 2005 crop, with an estimated 7X return, though the returns were primarily driven by a single company, Reddit, which was sold for a rumored 12M. With 5 companies gone and just one still going (Loopt having received an estimated 17M in further funding), there is still potential for one more exit and even higher returns.

The 2006 year has been more difficult with 9 of 20 companies gone already and only 1 exit to date (the sale amount is not known though I estimated 5M for the purposes of my model). Four of 20 companies received further funding and 6 remain alive but with minimal or no further funding. Based on these findings, the 2006 year has probably not reached break-even yet, though the portfolio still has some potential.

2007 has been strong so far with 5 exits, and making several guesses regarding exit valuation, there is a good chance that YCombinator has seen a two times return already on this year. With a record 11 of 31 companies receiving follow-on funding and still going, the 2007 group has a very large return potential.

I wanted to combine this estimated historical performance with what is likely to play out in the future. As I outlined in an earlier post on angel investment returns, the average holding period for an early stage investment is 3.6 years, and for investments that return 5X or more, that average holding period is 4.6 years. No program has yet held investments that long. If we estimate the future performance of these programs based solely on statistical data from early stage angel returns in the past:

1. Based on the number of companies funded and the expertise involved, there are likely still several home runs (10-30X return or more) that are still to come
2. The highest return opportunities in the portfolio are probably not yet realized
3. The fact that there have been some compelling exits to date means that the program is working as planned and is likely to show continued success

Therefore, based on my analysis, the model works and should play out very well for the investors. This does not mean every program will work, but the model itself looks like it will succeed and therefore it is likely several of the programs will be very successful.

With some of these programs succeeding, what does the future hold? There is no question we will see more of these types of programs emerge. The following graph captures the growth in seed capital programs from 2005-2008:

You can see we are on a steep and accelerating growth curve. So far in 2009, I am aware of at least five more programs that have launched, including most recently Capital Factory (Austin, TX) and GreenHouse (Ireland) both of which have surfaced since I prepared my first list.

One thing that will be very interesting to watch is how these programs develop in the area of funding/backing. By looking at the existing programs, and making some educated guesses based on the people involved and what I could dig up about each program, I put together this surprising pie chart:

This shows that over 60% of the existing programs have institutional support or backing, either from existing VCs or corporations. Only 17% appear to be funded exclusively by independent private investors and just over 20% are funded directly by the individuals running the program. This process involved making several educated guesses, but the bottom line is that by and large traditional early stage (angel) investors are not driving this trend, it is a handful of forward thinking individuals and experienced traditional VCs.

Looking forward, I would surmise that more programs will emerge having individual backing, as new geographic areas seek to put local programs in place and as the model becomes more widely accepted by angel investors. I know of several active discussions in this area, though so far, individual angels I have spoken to have not been particularly receptive to this new model – preferring to pick and choose their investments like they always have. Unfortunately, that model is increasingly not competitive with the fast-moving pace of Internet companies where business plans, waiting for monthly meetings, and extensive due diligence do not support the fast-time to market many ideas require. However, that is changing as evidenced by Paul Graham recently announcing his own training sessions for new angel investors.

Should you as a founder of a new software company seek to join one of these programs? Some have commented on the equity stake these programs require, and feel it is too much. I, personally, do not think so. As I commented in an earlier post, the implied valuations of these investments are not unreasonable for a new product at the idea stage with an unproven team. If the company is successful, a 6% holder will not materially impact things. If the company is not successful, well it does not really matter. If the programs are working out for investors, they are certainly working out well for the founders too.

On balance, I believe the value these programs can provide to an inexperienced team is well worth the investment. Many have commented on the quality of the program and the overall value of the experience. Raising money is always about who you know and the advice you get and rarely about the business plan. A local VC I know even stated “I receive a lot of business plans and have yet to invest in one.” A start-up company has so many challenges, they should take every opportunity they can to get help, advice, and support, and I don’t think a 4-10% stake is unreasonable for 15-75k and a lot of help.

In the end, I think the real decision on whether to sign onto a seed capital accelerator program comes to the team. For a brand new team with few family ties and limited startup experience, the decision is a no-brainer and they should seek a program with lots of support but possibly a smaller capital infusion. These teams can go anywhere and work out of hostels for the duration, if needed. And if they will fail, then it is best to fail-fast and move on. For a team with more experience, gained through working in larger businesses or prior startups, who can tackle industry-specific problems and even put a lot of their own time and money into the business, a better fit could be a more flexible or regional program with larger capital resources and a more flexible support model.  If the opportunity is large enough, these programs can help you get on the radar screen of VCs and open doors along the way.

The biggest advantage to the seed capital accelerators is the efficiency it brings to the market – the entrepreneur spends less time chasing dollars, the capital goes to work more quickly, and ideas are tested and validated faster. If you apply and don’t get in, move on - the most important thing is to get on with building your business, no matter what path you take. I have seen too many startups lose weeks and months seeking funding and ending up in a position where they can no longer survive without the money, because they stopped building the business along the way.

To start, we should ask the question, “why are these programs emerging now?” There has to be a first time for everything, of course, but despite various investors and incubators offering ‘high touch’ services in the past this sort of program did not emerge in a structured, systematic way until Paul Graham started experimenting with a new model of “angel investing” back in 2005. Paul was a relatively new investor, was a creative thinker, and was not tainted by the old ways.

Paul was also an avid hacker and realized that a number of trends were working together to make the cost of launching a software company much cheaper, especially one which delivers its product or service through the web. The most important driver was the emergence of powerful, free open source solutions (LAMP) and related frameworks, and the continued rapid decrease of hardware and hosting costs. A software company today can have in one month what would have taken a year or more to build only a few years ago. Guy Kawasaki, the founder of Garage.com and a well respected start-up expert, provides a good example of launching a new company for $12,000.

Even Microsoft, with a technology platform traditionally requiring relatively expensive development tools, is adjusting to this new reality. In 2008, they introduced the BizSpark Program (note, First Ascent Ventures, LLC is a BizSpark Network Partner). With this program, young start-ups can get full-on Microsoft development tools and platform products at no cost to use for their start-ups.  I think this is a very smart move for Microsoft: a start-up launching a new product or web service with a budget of $10,000 just could not afford to get full Microsoft licenses, and Microsoft was not getting in on the ground floor of these new companies as a result.

With products cheaper to build and launch, clearly the level of funding required to test out new ideas was also getting much smaller. Unfortunately, this goes directly against recent trends regarding the flow of money into the traditional venture capital market. So much money has poured into private equity and venture capital in recent years that fund sizes have been driven higher and higher and thus average investment sizes have stayed large. Although recent economic factors have put a wet blanket over venture capital generally, the trends still point up and fund sizes remain very large by historical standards. Just recently, a Morgan Stanley report found that public pension funds are looking to increase their exposure to private equity as a category. VC funds are still being raised.

This shifting venture capital landscape is the second trend, and James Geshwiler picked up on this back in 2007, writing from his perspective working with angel investors. He was noticing a rapid rise in the number of angel groups, and an increasing pooling of angel dollars to drive more efficiency into a very inefficient segment of the market. These groups were rising to fill a void being left by the growing size of venture funds and their associated investments. Paul Graham, with YCombinator, and later David Cohen, with Techstars, and eventually a long list of others also found ways to fill this void – with a model that could operate even faster and more efficiently than the angel investors.

The third major trend opening the door for a new model was the increasing role of the Internet in providing a platform to deliver new services to the niche markets characterized by the Long Tail. The long tail represents smaller and smaller niche markets, some of which may live on happily in obscurity while others may suddenly explode in popularity according to popular culture or trends. The presence of the Long Tail, combined with a lower cost of entry to launch products or services to these niche markets, means many more web businesses can be launched and tested for given pool of dollars.

As Clay Shirkey explains so convincingly in Here Comes Everybody, open source is successful not because open source is easier or better, but because the cost of failure is so low. With the cost of failure near zero, many more ideas can be attempted and the likelihood one of them will turn out to be a big success is higher. The chance of failing is no less for any given idea. This is exactly what seed fund programs achieve with start-up companies. By putting small amounts of capital into many ideas, the cost of failure is reduced and many more ideas can be tested in the market. Some are bound to be winners. Ones that don’t make it do not go down in flames because very little capital was put at risk – the cost of failure is low. And by providing a strong support net and education program, seed fund programs do their best to shift the odds of success in their favor.

Systems that work like this are generally characterized as open systems or open platforms. Publish everything and let the appropriate filters weed out what does not make sense. Clay talked further about this in his keynote at the Web 2.0 expo last year. In the case of start-up companies, the filters are the customers. Many new products and ideas are released as free services first, in an effort to have the lowest barrier to entry and learn what works as fast as possible. Paul Graham actually recommends start-up companies think of themselves like non-profits in his Be Good essay.

Interestingly, with less capital at risk, smaller investments, and smaller fragmented markets being served, there has been an increasing prevalence of small, strategic acquisitions in the software sector – the fourth and final trend supporting the emergence of the seed fund programs. When companies can be built cheaply, they can also be sold cheaply. The traditional venture model, however, does not easily support small, modest exits - because the investments are larger, the exits also need to be larger. Angels long participated in modest exits for their portfolio companies. Seed fund programs take this to the extreme. They can put as little as $10,000 into a company, which if it sells for as little as 1M can still drive an 8x return for the investor. One 8x return can smooth over several failures.

Current market conditions generally support a continuation of smaller, more targeted M&A deals. With public equity values down, stock becomes an expensive commodity to use to buy companies. In the last quarter of 2008, 85% of deals were done with cash, according to a report by the Software Equity Group (executive summary available with registration). With more M&A targets available in the market, and the cost to acquire them lower, companies can be more active in using smaller-scale M&A to supplement their own internal innovation and find the exact “bolt-ons” that complement their strategy.

In the 3rd and final post on business accelerator seed fund programs, I will closely look at three key questions: Are these programs successful at delivering a high return for their investors? Should start-up companies apply to these programs? What does the future hold?

“Business accelerator” as a term emerged during the dot-com bubble as another name for business incubators, trying to distinguish them from traditional incubators which primarily provide cheap office space and a host of business services to early stage companies in many industries. The number of traditional incubators has increased very rapidly in the past 20 years, there are now hundreds if not thousands operating in the US alone. For example, browse this partial directory.

In the past few years, the term business accelerator has made a comeback to describe a new class of early stage development program that combines the elements of traditional incubators, small amounts of equity-based funding, and in-depth coaching/mentoring. Other names for these programs are micro-seed funds, business growth accelerators, or boot camp programs. This new type of program has primarily emerged in the software and web space. Typically they deploy a new pool of capital and invest in a new “crop” of companies at least once a year.

For the purposes of this article, I will look at programs that specifically combine “small” amounts of equity funding with a strong training or support program. By “small” equity funding I mean levels that are smaller than any traditional VCs, but which in some cases may overlap with angel investments. The difference between these programs and most angel investments is that these programs often invest in a group of companies all at once, do not rely on individual investors to make decisions (the people running the program decide), and typically provide a higher touch relationship (at least for the length of the program) than a normal angel investor or investor(s) would.

Within that definition, I am currently aware of 27 programs that fit (if you know of others, please share them via comments):

The most attention seems to follow the programs with the lowest level of investment funding – what are sometimes called the Micro Seed Funds. That may be because these groups are taking greater risks on unproven ideas at the edge of market innovation. This category contains a number of well known programs such as YCombinator, TechStars, Launch Box Digital, and others which generally focus on micro-seeding a large number of companies (10 or more per year). Micro-seeding means making investments of between 10 and 30k per company for small equity stakes, and hoping a few of them make it. One exception is Seedcamp which gets a lot of attention in Europe and typically makes slightly larger investments.

Even though significant deal vetting and filtering is performed by the teams running these micro seed programs, they have sometimes been described as a “spray and pray” approach: spray little bits of capital onto as many good ideas as possible, help them along, and pray some eventually strike it big. The small funding amounts are combined with an intense bootcamp program usually lasting several weeks to several months, and introductions to angels and VCs helps get the best companies to the next stage. Following graduation from the program, companies are somewhat “on their own” to get to the next level. Portfolio companies usually start at the idea/prototype stage with a team of 2-3 people and a lot of flexibility to live on little income and work 24×7 cranking out code.

Several programs attempt to operate with larger amounts of capital and in some cases put more of a focus to the investment model (iPhone apps, Google gadgets, etc). These programs attempt to make better and fewer selections, and by nature of the fund purpose and/or a longer term company support program hope to succeed with a portfolio of more targeted investments. Development program structures can vary, with some providing support for up to 9 months or more, others only a week, if at all. Funding levels for programs in this category range from 30k to up to 100k in initial capital. Some examples of programs in this category are Bootup Labs, Seedcamp, and the fbFund. The programs may compare most closely with a traditional small angel investment round with one or more very involved investors (guardian angels). This level of program seems less developed and less proven, so far.

The biggest spenders in the general category of seed fund programs are organizations that operate more like mini-VCs by putting 100k to 300k into selected companies, who are then part of the investor’s “portfolio” for an extended period of time. These programs provide regular and substantial customized support to the entrepreneur over time, rather than a one-time structured bootcamp. Examples of these programs are Monster Venture Partners, CRV Quickstart, and Digital Assets Deployment. These programs operate using compensation formulas that differ from the traditional venture model (which is 2% of assets and 20% of profits) but exact specifics are not available. Rough numbers from Digital Assets Deployment show that they deploy 2-3M or so in capital a year with a team of 3, which must put expenses somewhere in the range 5-7% of assets. The justification is based on the larger time commitment and potentially greater returns of working with companies from the earliest stages.

Having watched these programs develop, and keeping many of them on my Google alerts list, I do not see this as a fad or bubble. Factors in the marketplace, particularly related to the software and Internet sector, have significantly shifted over the past several years. Because of that, this new model of early stage investing has emerged to fill a growing need - and is here to stay.

In the next post in this series I will look closely as these market factors, why more of these programs are emerging, and what it might mean for investors and entrepreneurs.

Over the past month, the blogosphere has been awash in posts describing a number of negative developments in the venture capital industry. Even USA Today ran a short piece last month talking about the venture capital downturn. For companies seeking funding, it is safe to assume things have become more difficult now at both the angel and venture capital level. But the available data does not show a significant downturn, at least not yet. So how much should an early stage software entrepreneur be concerned about these developments? How big is the issue, and is the funding window closing? This post will take a look at some of the reports, the latest data points, and what they may mean to early stage software companies.

VC partners I have spoken to directly in the past couple weeks are very concerned, and describe the current environment as one in which “capital is becoming scarce.” Much of this is driven from a need to conserve capital to weather a downturn, but also unknowns regarding their ability to raise new funds or get currently committed funds in a timely manner. Several posts ago I mentioned the developing risk of Limited Partners (LPs) in venture funds not being able to meet their capital call requirements, or in some cases, VCs requesting dollars earlier than needed to try to get their money. Recent reports from PE News, Silicon Alley Insider, and lalaNews indicate that the risk is playing out. The bottom line is that many VCs need to make their current capital last longer, which means they will be more selective in doing new deals while preserving more capital for existing portfolio companies.

Looking historically at venture fundraising, the past 3 years have seen the largest amount of venture capital raised in any historical period outside of the 1998-2000 bubble. This chart shows fundraising data since 1995:

So the one bright spot is that there is still an historically high level of capital out there, even if firms are being much more conservative in spending it. And, even with this downtrend, total investment in the first 3 quarters of this year (at all stages) has already exceeded TOTAL 2005 levels, and the full year is likely to exceed 2006 levels, maybe even 2007 levels. Despite the claims of Adeo Ressi, venture capital is not quite dead yet and we are coming off a high level to begin with.  But this data captures deals that are already done. What about new deals?

In the past 2 weeks, I have seen several examples of established companies failing to raise money. Ambric, a company out of Portland (OR) in which I am an investor through a fund, shut down last week and is being sold because they could not raise more money. This is a company with top-tier backers and a strong technology and patent portfolio. I know the CEO of a Massachusetts-based venture funded company who cannot or will not seek another round, due to market conditions, and is going to sell. Another local investor I know has a portfolio company that failed to secure a Series D round, and will go bankrupt or be sold. This is just in the past 2 weeks and represents a noticeable uptick in failed financing.

However, deals are still being done. Each day VentureWire, Tech Wire, and other services report new financings. VCs are still out there scouting for good deals. One firm that is not slowing down seems to be Advanced Equities, a late stage venture capital firm that draws capital from hundreds or thousands of individual investors and pools it to make sizable investments in primarily later stage companies. My contact at the firm stated that opportunities remain strong and some clients are increasing their allocations to take advantage of valuations that are up to 50% off where they were at this time last year.

Fortunately software, as a category, needs venture capital much less than it ever did before. You may have heard the phrase “500k is the new 5 million.” Software companies can be launched much more cheaply than in the past. If bypassing or delaying venture capital is an option for you, I seriously urge you to consider it, as it keeps your exit options much more flexible and will save a lot of time, especially now, which could be better spent on product development or taking care of your customers. For some motivation I suggest reading this post at Dogster.

Pullbacks, even good size ones, are a normal part of the venture cycle and do not necessarily mean a reduction in market effectiveness or even the lowering of overall technology innovation. Instead, they can lead to higher efficiency in the market – less copycat deals, squeezing out of some weaker VC players, less funding of bad ideas, etc. The industry overall has historically had boom and bust cycles like every other sector, and VC funds are particularly bad at self-adjusting to market cycles. For a perspective on this, I refer you a very worthwhile article from 2002 by Josh Lerner from Harvard discussing the natural boom/bust of venture capital and its impact on innovation. Although written following the burst of the Internet bubble, it seems just as applicable today.

When it comes to angel investors, I also see some real weakness. Some individual investors are less able to do deals, and others will certainly be more selective. “I will only invest in companies with solid revenue,” or “I am going to wait for valuations to come down” are comments I have heard. Individual investors face the same challenges as the LPs, with portfolios devastated by the market and potential challenges in liquidity. But despite this, I can assure you there are individual investors that still want to make investments.

I have watched carefully the activity following the Speed Venture Summit, which was held here in New Hampshire about a month ago. The event was a huge success – being oversubscribed by both investors and presenting companies. In fact, 50% of the companies which applied could not get accepted due to space limitations, among other reasons. The event was intense, full of energy, and very worthwhile for everyone I have spoken with who participated. Looking at deal follow-up, interest remains high with many investor/company matches. There are definitely deals to be done for the right businesses with strong market opportunities. Be prepared to compromise on valuation, however. One consistent theme I heard from all the investors at the summit was “All the valuations were far too high…”

So my conclusion is that we do need to believe most of the hype. Every sector of the economy has been hit harder than initially expected, why would venture be different? Fundraising is difficult, but not impossible. A lot of pain will be felt by companies trying to raise B, C, or even D rounds who took money on a higher valuation 9-12 months ago. It may be hard to get initial attention for an A round, but a strong idea will get looked at - especially if it can help companies in this environment. There are opportunities available right now for companies that can seize them.

Some of the best strategies I see for early stage software companies right now are:

• Put together a board of advisors. Good people are out there and may be more willing to spend time on an exciting idea.
• Go heads down and build product. Now is an excellent time to put the blinders on and write lots of code, ideally working with a small number of clients to solve real problems that will help keep them afloat.
• Start a company if you have a strong idea and access to a small pool of funds or can self-fund for a while. Everything can be had on the cheap from space to help to equipment and services. Even great Microsoft development tools can be secured cheaply now through the new BizSpark Program (NOTE: First Ascent Ventures is a Microsoft program partner). Build modestly to put yourself in a strong position 12-24 months from now. Part-time is always an option too, while keeping the day job.
• Seek strong talent on the cheap, if you can land new projects or grow. People are more willing to work for less and take upside on equity. Recruiters are reporting candidates typically choosing more stock over money in negotiations right now.
• Seek opportunities for viral marketing, word of mouth, partnerships, and maximizing the leverage of the Internet.
• If you need to raise money, bring to the table a low-budget plan that demonstrates sensitivity to the current market conditions and minimizes your dilution due to a low valuation.

So with this post, enough about the market! It is time to get back to building companies and doing deals. Coming soon is a look at the emerging category of seed funds/business accelerators and the increasingly important role they are playing in launching software and Internet companies.

For example, I was speaking recently with the UNH computer science department head, Phil Hatcher. He indicated that the number of computer science program enrollees remains 50% below 1999 levels. It seems many future software professionals were left with a lasting bad taste when the bubble burst last time. In addition, many students think all the software development jobs are eventually moving overseas. With the rise of Web 2.0 and a whole category of new web-based business opportunities, I really thought we were finally climbing out of those dark days and software was “cool” once more.

But now it has started again.

Earlier today, I saw this summary of software and technology job loss announcements from the past week. That is a lot of activity. And so many appear to be missing from the list. eBay announced a 10% workforce reduction. Zillow announced cuts. VoIP startup EQO slashed its workforce by 65%. One week ago, my former employer, Chordiant Software, announced a 13% workforce reduction. Word on the street is that cuts at Yahoo are coming soon. Even Google, which is holding up surprisingly well in this market, has cut new hiring by 75%. A pretty strong statement from the world’s leading technology company.

The big buzz this past week was the secret Sequoia Capital meeting, which has been written about extensively over the past week (see venturehacks and Silicon Alley Insider for example). In summary, the renowned VC firm convened all their CEOs to a secret meeting and gave them a very strong message regarding the current downturn and what was going to be required to survive it. If you haven’t clicked through the presentation yet, you really must - it makes for interesting but very scary reading. One statement is now burned into my head, and this one phrase pretty much summarizes the whole presentation: “spend every dollar like it is your last.”

Not everyone is doom and gloom on the outlook for start-up companies, as Kevin Ryan outlines in this short post. But that was two weeks ago. That is a long time ago in the current environment. With the Sequoia meeting, the world may have changed.

My advice to small or emerging companies right now is plan to do more with less. A lot more with a lot less. Make sure your personal financial needs are as low as possible. If you are seeking capital, expect investors to be very cautious - especially private/individual investors. Expect to get less money than you want, and give up more than you want in the process. But if you can secure a little financial coverage now, this could be an excellent time to hunker down, crank on your product, and diligently work those one or two critical clients. The economy is not stopping. Professional investors remember that investments made in 2001-2002 were some of the best performing of the decade. Hard work and flexibility as a team, and low run rates, will be your friend for the next several quarters.

VC investments in start-ups remained robust through the exit drought… This suggests a trends of more accelerated investment at both ends of the pipeline – in start-up/seed companies and in more mature companies… this continued funding appears not to be impacting VCs’ ability to feed seed companies and keep the pipeline full.

We will see how this holds up over the next few months, but this is certainly good news at the VC level. As far as individual investors are concerned, unfortunately I think that the situation has finally changed. Why? The reasons are probably many, but here are a few of the top ones:

1. Cash is king right now. Everything else seems to be losing value, and in some cases dramatically over the past couple of weeks. Investors with cash are hesitant to part with it – and those that have investable assets tied up in mutual funds or stock portfolios are less willing to liquidate those investments to make new investments. Suddenly a 50k investment becomes a 70 or 80k investment, if it means locking in stock market losses on what was 80k in holdings just 6 or 12 months ago.
2. Asset allocation. Many individual investors approach their investing strategy using asset allocation, meaning establishing a target investment model such as 40% stocks, 20% bonds, 10% real estate, 20% private equity/angel investments, etc. With stocks and related investments down significantly, some investors have suddenly become over-allocated in other investment types – such as angel investments, which are not liquid. As a result, the investor may contribute any new investment capital to the other investment types in an attempt to rebalance the overall target allocation.
3. Early capital calls. I have heard rumors that some venture firms are starting to make early capital calls, a scenario that could be very bad for the venture market. What this means is that venture firms make an early request for installments of committed capital from the institutions and individual investors (the limited partners or “LPs”) that have signed on to participate in a fund. The VC firms may do this because they are concerned that this capital may no longer be available or won’t be available in the future. So they request the money now. This is basically like a run on the bank in the venture market, though in truth the money has not been loaned out as with a traditional bank. But the money could be sitting in other, depressed investments that the LPs do not want to liquidate or that now no longer hold enough value to be liquidated and fulfill the capital requirement to the VC firm. This would be a big problem as it would suck up liquidity.

Based on these factors and the general mood of investors I have spoken to, I think doing a deal right now will be harder than it was just a few months or weeks ago. But in spite of all this, history suggests that many of the strongest companies are started during times like this. As an example, earlier this week I attended the MIT Enterprise Forum in Manchester, NH, and Paula Long was interviewed for about 30 minutes. Paula Long is one of the founders of EqualLogic, a Nashua-NH based company that was sold to Dell, Inc. for 1.4 billion dollars in cash in late 2007 (according to VentureBeat, EqualLogic was in fact the largest *ever* all cash technology acquisition of a private venture backed company). EqualLogic was started 2001, during the darkest days of the post-Internet bubble, by three founders who had just left a failed start-up and didn’t have any new jobs. 7 years and 400 employees later, the company was sold for over 4 million dollars per employee. Amazing.

For the founding team of a new company, now is the time to put in the hard work, hang-in there, do not spend a penny more than you have to, and work hard to build a small number of key customer relationships – and of course, cling on to the relationships and customers you do have. Focus your story and value proposition on a problem customers are having in this economic environment. Mitigating risk, reducing costs, helping to keep good employees – these are all problems companies are facing right now more so than at any time in the past 5-6 years.

One bright spot is that the overall amount of new venture capital being raised seems to be holding up. In many cases, that capital will go to support companies already within the portfolios of venture firms – who will also need more support- but there will also be opportunities to make smaller bets on sound new ideas. Anyone that can secure customers and validate a business proposition in this environment is probably in a good position to get some attention, and given valuations are likely to be lower, investors that have cash are actually in a very good position.

When things start to turn around, which they always will – potentially very quickly when it happens – it will be too late to get new companies started and those that survive now have an opportunity to build on a validated business model and a strong foundation. But the next 12 months could be tough, hopefully not a nuclear winter, but it certainly will be harder and take longer to raise money for most companies.

The event is structured after speed-dating, and each company will have 10 minute appointments with potential investors for 3 hours during the main part of the event. Following this, there will be a 2 hour networking session where doors will be open to additional individuals from the community and industry. The idea is not new (see for example Funding Universe and Start-up speed dating), but this is the first time that I am aware of for this type of event to be held in NH, and given how successful it looks like it will be, there is a good chance the event will be an annual one.

With only 10 minutes, it is critical that presenters have a brief, clear story to tell, and the goal is to generate enough interest to secure follow-up meetings with potential investors. Given this, I wanted to offer some suggestions for presenting companies, from the perspective of a potential investor. These suggestions generally apply to any investor presentation, but with only 10 minutes, it is critical that the message be crisp and clear at this event.

So here they are:

• Sell your business, not your product. Too many presenters focus far too much on their product, not how the business will succeed. Selling the business means briefly describing the market opportunity, what will you sell, who will buy it, the competitors and how are you unique, and what your business model is. 2 minutes.

• Talk about the people involved – most investors will get behind strong people above almost anything else. Investors want to know you have what it takes and are 100% committed to your business. Some will want to see your house mortgaged too. Communicate why YOU are the team that will make things happen. 1-2 minutes.

• State why you need funds and generally what they will be used for. State the goals that will be met and why the company will be more valuable – “hit 2M in revenue in 2009 and reach break even.” Briefly mention the desired deal terms and if you expect to need more funds later. 1-2 minutes.

• Explain why this is a good potential investment. You need to convince the investor they will make an excellent return in a reasonable period of time. Refer to my prior posts so you understand the investor expectations. State your exit strategy – more than “sell the company” – state who will want to buy it and why. Mention any recent comparable deals and the multiples. 2 minutes.

• Leave time for questions. Don’t try to cram so much in, that you are pressed for time. Wrap up in 6 or 7 minutes and let the investor ask questions – you will learn a lot from what they ask, and the investor will appreciate your brevity and their ability to stay on schedule. 2-3 minutes.

Remember, your goal as a presenter is to get the investor’s interest and score a follow-up meeting - there will be plenty of time for the details later if you succeed here. Less is more. Consider leaving an Executive Summary with the investor that highlights the key points so they won’t forget, after hearing as many as 9 more pitches after you. And most of all, remember to have fun, meet some people, and learn from the experience!