[Dave Heal's] Observations & Reports

Shortly after I moved to Boulder in mid-August last year I became obsessively interested in the local VC/startup scene. I’d filled my RSS reader with some of the obvious must-read blogs, ordered a few nerdy books from Amazon, and jumped in hoping to meet some entrepreneurs and venture types and soak in as much information as I could. One of the nice things about the tech venture scene is that it’s relatively small, and the magic of the Internet makes it feel smaller. The big players are rabid techophiles and many of them blog and tweet regularly. So when Paul Graham tweeted that “convertible notes have won,” it triggered a massive response. As someone just starting to learn the intricacies of venture financing, this was great timing. But the sheer amount of text I had to wade through was overwhelming, and some of the best distillations of the issues were to be found buried in the comments sections.

This post is not an attempt at a comprehensive diagnosis. Instead, I’m aiming to create a resource for folks that want to understand, fundamentally, the terms of the discussion surrounding convertible debt v. equity financings in angel/seed rounds. I’m less interested in whether Paul Graham is right and more interested in what VCs and entrepreneurs are and should be thinking about when deciding how to structure their first round of financing.

World’s Briefest Executive Summary: aka The “tl;dr” Version

Convertible debt is arguably better for the entrepreneur in the short run, much less good in the long run, and often bad for the investor, which badness often redounds upon the entrepreneur thus canceling out some of the benefits.

What are we actually talking about?

Convertible Debt

Convertible debt is a security that involves issuing a promissory note to investors–a loan to the company, essentially–that automatically “converts” to equity in the company after a triggering event. This event is usually what is referred to in the documents as a Qualified Financing, which is normally (but does not have to be) a Series A Preferred Stock issuance. The Note will specify both the amount of money that will trigger the conversion and the amount of stock that the debt has been converted into, expressed in the form of a discount rate. For instance, a discount rate of 20% entitles the holder of the debt instrument to shares at 80% of the per share price. Ryan Roberts, who blogs as The Startup Lawyer, has a good, simple illustration of the process:

Here’s the basic outline of how convertible debt works:

(1) Joe Angel invests $100,000 in Startup.

(2) Startup issues Joe Angel a convertible promissory note for $100,000. The convertible promissory note has an automatic conversion feature at $1,000,000 (the “Qualified Financing”) with a conversion discount equal to 20%.

(3) Startup closes $1,000,000 Series A Preferred Stock round (the “Qualified Securities”) by a VC at a Series A Preferred Stock price of $1.00 per share.

(4) Since the Automatic Conversion feature in Joe Angel’s convertible promissory note is triggered by the Series A round, Joe Angel’s convertible debt will be converted to Series A shares at a per share price of $0.80.

(5) The Startup issues Joe Angel 125,000 shares ($100,000/$0.80 per share) of its Series A Preferred Stock. The convertible promissory note is cancelled.

And boom! Everybody’s rich! Errr…wait.

The other relevant feature of these convertible notes is the price cap. Many (most?) angels (Yuri Milner and some others excepted) will not invest without one, and the debate that Paul Graham ignited I think implicitly carries the assumption that convertible debt rounds contain a cap :

To provide upside protection, angel investors like to put a “price cap” on the convertible note discount. This price cap is expressed in terms of a pre-money valuation and effectively acts as a share price ceiling. Thus, an automatic conversion discount with a price cap might read something like this:

“The conversion discount shall be the lower of (i) a 25% discount to the Series A Preferred Stock share price, or (ii) the price per share if the Series A premoney valuation was set at $[10,000,000].”

The latter valuation figure is typically north of what the valuation would have been had the investor and company agreed on a firm price for the debt financing but lower than the best case Series A valuation. It should be obvious that this can backfire on the entrepreneur depending on how the second round of funding goes. If the investors put in $500k convertible debt at a $4.5 million pre-money valuation, at best they stand to get 10% of the company. But that next round of financing might turn out to be less than that first valuation. Essentially, the lower your pre-money Series A valuation, the larger the share of your company the investor gets.

Example from Ryan Roberts:

EXAMPLE 1: If a VC invests $2,000,000 at a $5,000,000 pre-money valuation ($7,000,000 post money) and an angel investor has a $100,000 convertible note with a 25% discount, the angel investor will own 1.9% of the startup immediately after the Series A round.

EXAMPLE 2: But if the VC invested at a $15,000,000 pre-money, the same angel investor would own 0.78% of the startup right after the Series A.

Because of this quirk, an angel investor may not have much incentive to help increase your pre-money valuation before a Series A…regardless of the conversion discount. Meanwhile, you and your co-founders are doing everything possible to increase the startup’s valuation.

What’s the alternative?

There are obviously quite a few permutations available as an alternative, but the standard equity financing usually referred to in the debate is a priced Series A preferred stock financing. Preferred stock comes with rights that are senior to the company’s common stock (usually what is issued to founders and employees) and usually entitles the holder to any number of other attendant benefits. Preferred stock normally comes with, inter alia:

1. Liquidation preference: The LP is generally what is meant by “senior to” above. This gives “preference” to the preferred stockholder in the event of a liquidation event and means that they will get their money before the holders of common stock. This can include a company sale, merger, or, on the opposite side of the emotional spectrum, dissolution of the company. It does not include an IPO, in which all preferred stock converts to common stock. Relatively straightforward stuff at its most basic level. Liquidation preferences can get much more complicated, so if you want the advanced tutorial, check out Yokum Taku’s post.

2. Anti-dilution protection: Like the LP, this is a basic concept with a great potential for complicating nuance. This provision is used to protect the investor in the event that the company raises money at a lower valuation than previous rounds.

Yokum Taku:

Preferred stock is normally convertible at the option of the holder at any time into common stock, usually on a share for share basis, and is typically automatically converted upon the occurrence of a qualified initial public offering. Price-based anti-dilution adjustments involve increasing the number of shares of common stock into which each share of preferred stock is convertible. In addition, an anti-dilution adjustment will affect the voting rights of the company’s stockholders because the preferred stockholder is almost always entitled to vote on an as-converted to common-stock basis. The primary difference between the various anti-dilution formulas to be described in upcoming posts is the magnitude of the adjustment under different circumstances.

For a brief course in Intermediate Anti-Dilution, check out Brad Feld’s Term Sheet Series post [covering weighted-average and ratchet-based anti-dilution provisions].

Preferred stock comes in a “participating” flavor as well. Whereas generic preferred stock gives the investor the choice between getting their money back or taking the equity share of the company they purchased with that money, participating preferred stock essentially gives the investor both.

Brad Feld:

A PP is the right of an investor, as long as they hold preferred stock, to get their money back before anyone else (the “preference” part of PP), and then participate as though they owned common stock in the business (or, more technically, on an “as converted basis” – the “participation” part of PP). It takes a preferred investment, which acts as either debt or equity (where the investor has to make a choice of either getting their money back or converting their preferred shares to common), and turns it into something that acts both as debt and equity (where the investor both gets their money back and participates as if they had converted to common shares).

To illustrate, let’s take a simple case – a $5m Series A investment at $5m pre-money where the company is sold for $20m without any additional investments being made. In this case, the Series A investor owns 50% of the company. If they did not have a PP, they would get 50% of the return, or $10m. With the PP they get their $5m back and then get 50% of the remaining $15m ($7.5m), resulting in $12.5m to the Series A investor and $7.5m to everyone else. In this case, the Series A investor gets the equivalent of 62.5% of the return (rather than the 50% which is equivalent to their ownership stake). The PP results in a re-allocation of 12.5% of the exit value to the Series A investor.

Preferred stock, while it almost always comes with anti-dilution protection & liquidation preferences, can also include rights to block or compel certain actions (company sale/IPO, increase the option pool, appointing senior executives, etc.)

Who likes what and why?

Why do entrepreneurs and/or VCs like convertible debt?

In summary, the conventional wisdom (which is increasingly superannuated) is that a convertible debt financing is faster and cheaper and likely to provide more favorable terms financial terms to the entrepreneur. It’s also (dubiously, some might say) attractive because it allows the entrepreneur to punt on a firm valuation until their next round and who doesn’t like procrastinating!

• Keeps legal costs down (reality: increasingly less so)

This is often repeated as a reason to do debt instead of equity. But most observers recognize that while this may be true up front, all this does is frequently defer the legal fees until a later round/spreads the fees out over a longer period of time. And with the emergence of a variety of streamlined seed documents, a priced equity round can be done for about the same price (~$5k with these non-negotiated “light” docs according to Fred Wilson, ~$15k with Series Seed according to Yokum Taku). For smaller rounds (

• Faster/more expedient (reality: true but increasingly less so)

In a convertible debt financing, the entrepreneur and the VC don’t have to sit down and wrangle over what the company is worth now. The common refrain is that while the pricing conversation around the cap may be similar to a true valuation, the cap discussion takes place at a level of abstraction that reduces the potential for contention. This often results in the entrepreneur getting a better deal, but as we’ll see below that “better deal” often results in misalignment with the interests of their investors, which ultimately creates its own set of problems.

Entrepreneur Lateef Johnson of Deckerton adds:

One thing I’d like to add is that delaying pricing not only shifts risk, it also protects the cap table, which may be more important. Angel investors chafe at the idea of getting worse deal terms than earlier investors, so delaying pricing means that all investors convert at the same terms, which reduces due diligence and speeds up the deal. Faster deals are probably more beneficial to some entrepreneurs than shifting risk.

• No control/rights issues to negotiate (reality: an issue, but the non-negotiated seed docs are, like convertible debt docs, mostly about economic structure)

Debt investing typically gives investors economic rights only. You’re loaning the company X amount of dollars. Equity investments, as discussed above, typically come with a variety of control rights written into the documents (board seats, right to block certain actions, etc.), and the laws of the state of incorporation will also prescribe a basic set of shareholder rights.

In a “blubble” environment like we have now, VCs might prefer convertible debt documents because they don’t particularly care about the control rights and simply want in on the deal. In Chris Dixon’s post on the subject he relates a bit of wisdom he learned from Ron Conway:

To the extent that I know anything about seed investing, I learned it from Ron Conway. I remember one deal he showed me where the entire deal was done on a one page fax (not the term sheet – the entire deal). Having learned about venture investing as a junior employee at a VC firm I was shocked. I asked him “what if X or Y happens and the entrepreneur screws you.” Ron said something like “then I lose my money and never do business with that person again.” It turned out he did very well on that company and has funded that entrepreneur repeatedly with great success.

You can hire lawyers to try to cover every situation where founders or follow on investors try to screw you. But the reality is that if the founders want to screw you, you made a bet on bad people and will probably lose your money. You think legal documents will protect you? Imagine investors getting into a lawsuit with a two person early-stage team, or trying to fire and swap out the founders – the very thing they bet on. And follow on investors (normally VCs) have a variety of ways to screw seed investors if they want to, whether the seed deal was a convert of equity. So as a seed investor all you can really do is get economic rights and then make sure you pick good founders and VCs.

Mark Suster chimes in in the comments to talk about a deal that he lost to Sequoia when he had a term sheet all but agreed-upon except for some “niggly founder issues” and Sequoia came in and swiped the deal without any fuss. Especially when it comes to smaller investments, VCs might be inclined to do a debt deal simply in order to avoid negotiating control issues. The “light” non-negotiated documents that Fred Wilson favors, however, look more like your standard debt documents and deal mostly with economic structure.

• Rolling fundings

Angel investor Chris Hobbs notes in a comment on Seth Levine’s post:

Another advantage of a convert is if you are going to fund in dribs and drabs. With a step up over time in the conversion discount, you can do a rolling funding more cheaply with a convert, and still have some accommodation for risk. I personally don’t like rolling fundings, however, as the founders tend not to get any work done when they are focused on raising money.

Why do entrepreneurs and/or VCs like priced equity rounds?

First let’s start with the hard sell from Ted Wang for his Series Seed documents:

· Costs should be roughly the same (if not cheaper) than using industry standard debt documents. There are a number of different convertible debt documents out there and there will likely be some back and forth whereas these are standard documents.

· Same point for speed. If parties agree to Series Seed Documents, should be faster than debt documents since there is some negotiation with debt documents from sophisticated investors.

· Series Seed Documents are transparent: no hidden gotchas can get served up in definitive documents. You can review them right now if you want.

· Equity documents give investors more clear definition around rights, more stability and less potential squabbling in the next round.

· Equity gives investors the opportunity to get long term capital gains tax treatment if early exit.

· With minor manipulation, Series Seed enables multiple board structures without tortured and non-functioning agreements (a real problem for convertible debt documents); and

· Entrepreneurs get price certainty instead of the lower of two different prices as with capped debt.

In sum, Series Seed creates a level playing field between capped debt and equity documents in terms of speed and cost. When one studies the (admittedly highly technical) benefits of Series Seed vs. price debt, Series Seed is a better solution.

• Alignment of interests

As we saw above, your standard convertible debt instrument includes a discount rate with a cap. But when intended as a bridge to a Series A round, something strange happens. This arrangement means that the incentives for the entrepreneur and investor are now at odds. The entrepreneur obviously wants the Series A round to the priced as high as possible, but the investor now wants the Series A round to be priced as low as possible because the conversion price is based on that round.

As Mark Suster puts it:

As an investor when you do convertible debt you’re usually pricing the round when the next money comes in. But as an angel you’re usually not only taking risks but also helping the company succeed (through introductions, social proof, coaching, recruiting). So think about it – why should you be penalized for helping a company to get a higher valuation in the next round and thus your money gets converted at a higher price?

If an entrepreneur wants an angel/seed investor who’s going to actually add value, doing a convertible note (without some pro-investor protection like warrant coverage or a discount rate that gets progressively more investor-favorable over time) might ultimately make less sense. The blogs of all of the prominent VCs I read reflect a unanimous desire to add value and so the choice of a financial instrument that might get in the way of that desire should not be taken lightly. As an entrepreneur you want your VC to want to help you, especially at the angel/seed stage.

Seth Levine’s take on why convertible debt might be bad for entrepreneurs:

Clearly in the short run this trend is positive for entrepreneurs because it has the effect of both deferring an often difficult conversation (around valuation) and ultimately increasing early stage company values and as a result decreasing entrepreneur dilution (by the way it’s also good for Y-Combinator, TechStars and other similar programs since the shares the program gets of each company act as founder shares in this financing equation). And I have no doubt that there will be many entrepreneurs who benefit from this trend. But it’s not clear to me that it’s sustainable (just as it wasn’t a decade ago). Ultimately investors need to be compensated for the risk they take in making their investments. With capital being relatively fluid (and the angel markets being finicky) as companies run into trouble, as valuation caps begin to be disrespected, as overall return profiles decrease because of higher early stage prices, money will flow out of the asset class. And ultimately this doesn’t benefit entrepreneurs either.

Yokum Taku also notes, regarding convertible debt deals:

Investors may request aggressive terms. For example, investors may require the company to grant a security interest in all of the company’s assets, personal guarantees from the founders, drastic measures upon an event of default (i.e. the equivalent of getting your arms broken if you don’t repay), etc. In a Series A financing, there seem to be some established norms on what is typical. In a convertible note bridge financing, creative investors may suggest some unusual terms.

Conclusion

So, in the end, what did we learn?

With the advent of the Series Seed and other “light” documents, a lot of the cost and time associated with equity financing has been reduced to levels that are competitive with a debt deal. There are still good reasons why both entrepreneurs and VCs might want to push the valuation discussion down the road, and protections can be built into the debt documents to make them more equity-like and therefore satisfy the VC. But most entrepreneurs taking seed financing want active, enthusiastic investors. And most investors want to be strategically involved in their portfolio companies. However, a vanilla convertible debt financing can misalign the parties’ interests in a way that will ultimately hurt the entrepreneur more than a low but reasonable valuation might have.

EDIT: Scott Edward Walker of Walker Corporate Law Group has a post that cautions entrepreneurs, especially ones at the helm of “hot startups” against agreeing to the Series Seed documents as-is. Solid advice that hopefully is rather obvious, but read the entire post.

Response to Paul Graham Link Round-up:

Seth Levine (Foundry Group): http://www.sethlevine.com/wp/2010/08/has-convertible-debt-won-and-if-it-has-is-that-a-good-thing

Yokum Taku (Lawyer at Wilson Sonsini): http://www.startupcompanylawyer.com/2011/01/09/is-convertible-debt-with-a-price-cap-really-the-best-financing-structure/

Mark Suster (GRP Partners): http://www.bothsidesofthetable.com/2010/08/30/is-convertible-debt-preferable-to-equity/

Jason Mendelson (Foundry Group): http://www.jasonmendelson.com/wp/archives/2010/08/the-convertible-debt-debate-an-ex-lawyers-twist-on-the-argument.php

Fred Wilson (Union Square Ventures): http://www.avc.com/a_vc/2010/08/some-thoughts-on-convertible-debt.html

Chris Dixon (Hunch): http://cdixon.org/2010/08/31/converts-versus-equity-deals/#comment-73535965

Ben Siscovick (IA Ventures): http://bsiscovick.tumblr.com/post/1043177410/advocating-the-move-from-entrepreneur-friendly-to

I’m making my way through the canonical* venture/startup literature and thought I’d try out a few different ways of reviewing the books. Epic poetry, rap homage, and Serious Book Review are all on the table for future iterations of this feature.

*By “canonical” I mean I asked a few friends and mentors in the industry to recommend stuff to read and these books were mentioned by more than 1 person.

For this first go around I chose William Draper III’s The Startup Game: Inside the Partnership between Venture Capitalists and Entrepreneurs and will be writing up one post per chunk of the book, where chunk is defined as the number of pages I read before falling asleep. I imagine this will amount to 2 -3 posts for the entire ~225 page book with the potential for a wrap-up post if there’s a sufficient amount of synthesizing that such a summary would be worth doing.

William Draper III is the meat in the single-decker sandwich that is the Draper Family Venture Capital Dynasty, which started with his late father (Bill, Jr.) in the mid-20th century with the formation of Draper Gaither Anderson, the West Coast’s first VC firm, and continues today with his son Tim, the founder of the iconic Silicon Valley firm Draper Fisher Jurvetson. If that family sandwich analogy makes you uncomfortable, instead imagine a family of Joe Montanas terrorizing the NFL for 40 years. Except instead of the NFL, it’s venture capital. You get the idea.

The sticker on the side of the book says “biography.” And although a good biography can be worth reading, the genre is littered with so much self-indulgent dreck that I did feel my forehead crinkle a bit with consternation when the book started out with a seemingly overlong anecdote about a quaint dining establishment. I steeled myself in anticipation of the portrayal of the quirky but resolute diner owner who would serve as a narrative foil for the entrepreneurs that we would meet in the rest of the book. And there is a bit of overwrought Gladwellian scene-setting in the first few chapters, with longish strings of adjectives describing people we don’t quite care about yet. It reminded me a bit of that Uncle–or dinner guest of unknown provenance–who has great stories but an anti-ear for detail. So, kind of like Thomas Friedman except with good stories. Draper does ultimately reveal himself to actually have been up to something with the inclusion of the first 10-20 pages, but there was just enough homespun fluff to get a guy worried.

Also probably turns out I was being a bit of a snob.

As someone who used to spend a lot of time reading Difficult Fiction, academic philosophy and other varieties of similarly wonky prose, I still sometimes catch myself needing something to be hard in order to feel like I’m learning. Although this book isn’t high concept or written with a whole lot of verve, it’s full of great information that would probably just be obscured by a more academic delivery. Draper’s family was there at the creation of the VC industry in Silicon Valley. He participated in or had front row seats for many of the legendary tech financings in the past few decades. The guy, unlike yours truly, decidedly does not need to dress up his story with a bunch of flowery adjectives or literary pretense.

For those familiar with the VC industry, there isn’t tons of new information in these first few chapters. But Draper’s retelling has the benefit of being informed by actually being present for much of the interesting history. His father’s firm, Draper Gaither Anderson was not only the first West Coast VC firm, but it was the first to use the now de rigueur corporate form of the limited partnership (in 1959). But the LP didn’t take off for a while. During the 60s and 70s (and even into the 80s), limited partnerships were still in the minority. Most funds were publicly traded closed-end funds, mutual funds whose shares must be sold to other investors rather than redeemed from the issuing firm, or SBICs, a new corporate form created by legislation passed during the Eisenhower administration.

In the late 70s and early 80s, money began to flow into the VC industry due in large part to the opening up of the industry to money from pension funds. Draper says on page 45 that “in 1994, the floodgates opened when the law changed and allowed pension fund managers to invest in venture capital partnerships.” I don’t know whether this is a typo or whether he has some other regulation in mind, but the generally accepted finger-from-the-dyke moment in the increase of the capital supply was the 1979 amendment to the so-called “prudent man” rule governing pension fund investments. A 1998 paper by Paul Gompers and Josh Lerner, What Drives Venture Capital Fundraising, details the history:

One policy decision that potentially had an effect on commitments to venture funds via supply changes is the clarification by the U.S. Department of Labor of the Employment Retirement Income Security Act’s (ERISA) prudent man rule in 1979. Through 1978, the rule stated that pension managers had to invest with the care of a “prudent man.” Consequently, many pension funds avoided investing in venture capital entirely: it was felt that a fund’s investment in a start-up could be seen as imprudent. In early 1979, the Department of Labor ruled that portfolio diversification was a consideration in determining the prudence of an individual investment. Thus, the ruling implied that an allocation of a small fraction of a portfolio to venture capital funds would not be seen as imprudent. That clarification specifically opened the door for pension funds to invest in venture capital.

To illustrate what this meant: following the rule change the percentage of total venture capital commitments contributed by pension funds went from 15% (in 1978) to more than 50% in only 8 years.

Draper tells the story of struggling to come up with enough money to start his own VC firm shortly after leaving DGA in 1962. Eisenhower’s Small Business Investment Company Act of 1958 established federally guaranteed risk-capital pools that became one of the dominant investment vehicles in the VC world:

By the time I left DGA in 1962, I had scraped together about $25,000 to invest in a new venture capital company. I had no other assets besides my $40,000 house, which had a $20,000 mortgage on it. Given that thin capital base, setting up my own venture firm seemed like little more than a pipe dream. But about that time, Al Pyott, a friend at Inland Steel [where Draper had worked before quitting to join his father’s nascent firm], sent me a copy of President Eisenhower’s “Small Business Investment Company Act of 1958.” I read it carefully and learned that if I could come up with $150,000 and invest it in an “SBIC,” the government would lend me up to $450,000 for ten years at five percent interest–in other words, three-to-one leverage. Bingo!

SBICs still exist today, but as Draper would soon discover, they are hampered by regulation that prevents them from becoming an engine for massive growth. As one example, investments in any one company were capped at $60k (not overall but per firm).

One bit of Silicon Valley history that I wasn’t aware of prior to reading the book was the role of Fred Terman, Stanford’s Dean of Engineering (and later Provost), in turning Stanford into an engineering powerhouse and magnet for entrepreneurial types. He single-handedly convinced Stanford, Draper says, to put massive resources into turning the engineering school into the best in the world, thereby kickstarting the Great Egghead Migration to Silicon Valley.

Much of the wisdom Draper shares comes in the form of advice that now seems old hat but which Draper had to glean for himself back in the days before there was an army of prolific VC bloggers. Draper talks about his investment in Raychem as equal parts faith in the company’s patented, heat-shrinkable insulation and a strong belief in the team led by found Paul Cook. This emphasis on the quality of the founders instead of their ideas is one that you’ll see repeated by almost all of the most successful venture capitalists. They make investments in people, not things. Companies frequently change tack more than once between an idea’s inception and its deployment as product. So it’s initially preferable to have a group of sharp, industrious people working on a dumb idea than a group of dumb guys working on a smart idea.

As with all books of this type, there is an editorially mandated list of distilled insights. I expect there will be a few more of these before we’re done, but the first such list is Draper’s Five Key Dimensions of VC, which leads off the second chapter on “How It [VC] Works.”

1. The funders
2. The team
3. The pitch, the product & the market
4. The deal
5. The relationship

The Funders

This is a fairly self-explanatory element of venture capital. Draper gives a crash course in the history of VC from the early days when funds were almost exclusively based in New York and run by wealthy families with names that you’d recognize (the Rockefellers, the Whitneys, etc.). Next in the evolution was the formation of what most folks consider to be the first modern venture capital firm, American Research and Development (ARD), which was formed in the aftermath of WWII by MIT President Karl Compton and HBS Professor Georges F. Doriot. Institutional investors were not yet on board with VC, hence the structuring of the firm as a publicly traded fund that was marketed mostly to individuals. Draper notes that the choice to make the firm public would ultimately be its undoing because of the strict regulation associated with public companies and the “impossible problem of trying to value a passel of private stockholdings for public shareholders.”

The Team

Two quotes about “the team” suffice to sum up this segment of the chapter:

1. “Nothing is more important. In fact, nothing is even a close second.”
2. “There are no strong companies with weak management.”

For an entrepreneur’s similar take on the theme, check out item #2 from Elad Gil’s 4 Ways Startups Fail:

2. Team implosion
Lack of clear decision making? Founders constantly fighting? Hiring a bunch of jerks that irritate everyone? A lot of companies end up imploding due to bad team dynamics leading to a lack of clear direction, internal infighting and backstabbing, and a terrible working environment.
Ways to mitigate:

• Make sure you and your co-founders have clearly defined roles and there is a single person ultimately in charge who can call the shots.
• Make sure you and your co-founders can communicate openly, have mature and frank discussions (can you give each other constructive feedback?), and are aligned on where you want to take the company (does one person want to sell early and the other wants to build a long term global business?).
• Have a high bar for culture and team fit for early hires. Correct hiring mistakes quickly.

The Product, the Pitch & the Market

I don’t want to spoil the joy of reading the entire book for you, so I’ll just note that Draper says you need to know these things well.

The Deal

This section contains some fantastic material on the types of deals that get struck, both between entrepreneurs and VCs and among entrepreneurs/founders. The bit of gold to be found in this section is the story Draper tells of one early-stage company’s rather unsophisticated valuation method:

An unimpressive team of young entrepreneurs came into my San Francisco office and made their presentation for a company that needed $3.5 million to get started. When they finished, I asked what they thought was a fair deal. They said that the company was worth $7 million and that two-third for them and one-third for us sounded about right. I asked how they had arrived at the $7 million valuation. The answer, which the CEO delivered with a straight face: ‘There are seven of us, and we figure that we are worth $1 million each.” I asked them why they didn’t pick up three more employees on California Street before they came in the door…”

Burn!, as the kids say.

Draper notes that, regarding the internal split of equity between the founders, if one founder is taking drastically more than the other(s), that’s a red (he says “yellow”) flag. For an extended discussion on the perils of founder equity, check out Mark Suster’s recent post The Co-Founder Mythology and Nathan Kaiser of npost with The only wrong answer is 50/50: calculating the co-founder equity split.

The Relationship

This section’s first sentence rhetorically asks, “Does the relationship between the entrepreneur and the venture capitalist go beyond money?” No points for guessing that the answer in almost all cases is “yes.” The one “practitioner story” from this section that caught my eye was Draper’s mention of his investment in OpenTable and the frequent strategic wrangling that he engaged in with the CEO, Thomas Layton.

When a reservation is made with OpenTable, each restaurant pays $1 per person. Draper wondered why they didn’t charge $2. Or why they didn’t have the restaurant pay up front for the computerized reservation system instead of leasing it to them.

Or why don’t we just sell them our software and get ouf of the hardware business entirely? They all love us, and right now we are too capital intensive.

This back and forth is used to illustrate the point that venture capitalists are supposed to be business advisers, not just piggy banks in ill-fitting, outdated sport coat and jean combinations. They’re supposed to bring their own entrepreneurial experience, or their wealth of industry knowledge, or their financial acumen to bear on the problems faced by their portfolio companies.

Earlier in this recollection, Draper recalls asking the hostesses at various restaurants around San Francisco what they thought of OpenTable.

After making the investment in OpenTable, I would ask the hostess how she liked OpenTable whenever I saw the computerized reservation station near the entrance fo the restaurant. She would always reply something along the lines of, ‘We love it. We can’t live without it. It has made reservations and our lives so much easier.’

If you were on the Internet last fall, this high praise may be creating a bit of cognitive dissonance for you. In October 2010, Mark Pastore of the restaurant Incanto asked Is Open Table Worth It? from the restaurant owner’s perspective. His answer:

Only one of the dozen or so I spoke with said he felt that OpenTable increased the value of his restaurant and that he wouldn’t imagine opening a new project without it. The rest were less than happy. The recurring themes were the opinion that OpenTable took home a disproportionate (relative to other vendors) chunk of the restaurants’ revenues each month and the feeling of being trapped in the service, it was too expensive to keep, but letting it go could be harmful. The GM of one very well known New York restaurant group, which spends thousands of dollars on OpenTable each month, put it to me this way, “OpenTable is out for itself, the worst business partner I have ever worked with in all my years in restaurants. If I could find a way to eliminate it from my restaurants I would.” Another high-profile, 3.5-star San Francisco restaurateur told me he feels held hostage by OpenTable. For the past several years, his payments to them have been substantially more than he has himself earned from 80-hour workweeks at his restaurant. But he believes that if he stops offering it, his customers will revolt and many would stop coming to his restaurant. So he keeps paying, but carries a grudge and wishes for something better.

Around the web there was and is a ton of complaining about OpenTable out there. Although as Pastore’s critique notes in good politicking fashion, it’s tough to deny that they’re a successful company by most metrics. Obviously OpenTable’s financial health is ultimately wrapped up in what both customers and restaurant owners think of the service. But the fact that this vignette already seemed dated was interesting to me and, I think, highlights the pace of change in the tech scene these days.

In the rest of chapter 2, Draper gives his opinion on the controversial subject of taxation treatment for the carry (usually between 20-30% of the profits) that constitutes most of the VC’s take-home pay. The issue is whether the carry should be taxed as capital gains (more favorable to VCs) or ordinary income.

I believe that capital gains tax treatment has worked extremely well, resulting in a huge boost to the economy as well as giving incentives to the individuals involved.

Draper also discusses one of the unique characteristics of his firm Sutter Hill, which is structured as an “evergreen partnership” and essentially means that it is an open-ended vehicle with no “artificial” expiration date. Most limited partners invest in a venture fund for a period of 10 years, and they’re usually not able to take that money out before the 10 years is up and the fund expires. Sutter Hill doesn’t raise separate funds–the nomenclature for the standard structure involves labeling each fund with a roman numeral, so a fund’s 4th fund is usually Unnamed Venture Fund IV, which was preceded by Unnamed Venture Fund III. Instead, they value the whole portfolio every four years and allow the LPs to take money out at that time.

This structure is one of the reason why the fund does so well, he says, in part because his firm’s structure better aligns the interests of the LPs and the GPs (the general partners/venture capitalists) and that the “series structure” of other funds often hurts the individual portfolio companies when the fund terminates. Maybe I’m missing something important here, but I don’t understand why this would be so. Most of the money in each “series” fund is invested in the first few years. So by the time termination of the fund is even on the horizon, we’re talking about companies that will likely be either obviously thriving or obviously on their way to the deadpool. His point does not seem to be that the condensed fund raising period at the end of the fund distracts the VCs from providing value but rather that the actual termination or threat of termination is the harm.

He probably has a point that the nature of the series structure–in which the first few years are spent doling out the money and the latter stages are spent managing the portfolio companies while simultaneously engaging in a new round of fund raising for the next fund–probably encourages VCs to push money into companies too quickly at times. But it’s unclear to me how a termination date 10 years into the future is the Sword of Damocles that Draper implies.

Sarbanes-Oxley: The IPO Maven’s MacGuffin?

About a month ago the Wall Street Journal ran an editorial that blamed the dearth of IPOs on Sarbanes-Oxley, the 2002 law enacted in response to the accounting tomfoolery of Tyco, Enron, WorldCom, etc.

The elephant in the room is the 2002 Sarbanes-Oxley law, which triggered billions of dollars in new compliance costs for public companies. But the accountants who profit from Sarbox and the Treasury maintain that the law is merely one of many factors discouraging new public companies. This view is shared by most in Washington because Sarbox was a bipartisan overreaction to the accounting scandals at Enron and WorldCom and was signed by George W. Bush.

The implication here becomes clear in the rest of the piece: those blaming the Death of the IPO on everything besides Sarbanes-Oxley are making a cynical, politically expedient argument.

The coalition that wants to change the subject whenever Sarbox is mentioned fingers other problems, some of which are real. Limits on immigration dull our competitive edge. Hyper-litigation is always a costly drag on U.S. GDP. Eliot Spitzer’s settlement over stock research on Wall Street reduced the analyst coverage for small companies and thus made it harder to get their story out to investors. A decade ago, “decimalization” at the stock exchanges delivered small savings for investors on each transaction but reduced the profits for brokerages, especially when trading small-cap stocks.

Valid points all, but when a young company rockets past $100 million in revenues and decides to remain private—a common occurrence lately—it’s not because the founders are waiting for a change in immigration policy. When Facebook, already one of the most famous brand names in America, decides to hold off on an IPO, it’s not because its executives fear a lack of analyst coverage.

Before we dive into the arguments, let’s understand a few of the reasons why companies have historically gone public. Among the many reasons are the following (admittedly interrelated) ones:

1. Raise money: This is obvious. IPOs were (are?) the easiest and most cost-effective way for a large company to raise a bunch of money and then have a currency with which to pay new employees or do M&A deals.
2. Provide liquidity for existing shareholders: Allow founders to sell some stock, diversify, get rich/stop being so damn poor and wean the kids off of hand-me-down crayons, etc.
3. Increase public profile/get brand exposure/enjoy momentary frisson of power: Go public and you get a lot of press. Some stodgy corporations may also prefer to do business with a public company because of all the supposed hijinks-quashing regulation that goes with the listing. Going public also seems to reduce the cost of getting credit from banks. You also get to go on a road show and drop a giant prospectus in people’s laps.

Dan Primack responded to the WSJ post and sensibly noted that the IPO market was declining long before Sarbanes-Oxley was passed in 2002. Although I would quibble with his title, which I imagine he didn’t choose. Regulation, broadly conceived, did indeed kill the IPO. To the extent that it’s been killed, that is, which leaves it probably somewhere right around Zombie; it used to be real dead but is now out and about trying to make a comeback.

And but sure, you can, as the WSJ did, find lots of surveys of company heads, both private and public, that will lament the bill’s passing and the absurd amounts of expensive red-tape bushwhacking that compliance involves. But to heap the majority of the blame on any one thing that happened as late in the game as 2002 strikes me as wrong.

The graph below shows the number of IPOs per year in the US (not just the venture-backed IPOs that the WSJ piece focused on). Obviously, there’s a definitional problem at play here as well: what counts as an IPO? FYI: this chart included IPOs only by operating companies, excluded those below $5/share, and those offerings that issued ADRs (non-US companies listing on American exchanges).

The data for 2009 and 2010 that I’ve seen have IPO levels steadily rising back up just shy of the levels of the mid-2000s. And in fact just yesterday Paul Kedrosky, in his Field Notes (link round-up), highlighted a RenCap post that says IPOs are “surging” in April, with a total of 31 companies filing with the SEC so far. It should be noted, however, that even if the number of total IPOs isn’t shockingly low, many of these companies are larger and the proportion of small to large cap companies issuing IPOs has changed drastically in the past decade or two. The WSJ definitely got that piece right.

So, I think there are two separate threads worth exploring here. What killed the IPO market/How dead is it? And if it’s dead or at least permanently depressed from mid-90s levels, should we care? My admittedly arm-chair answers are: Yeah, it’s pretty dead, especially for small cap companies. And yes, we should care, but maybe not as much as people would have you believe.

Historical Perspective on the Death of the IPO Market

 

To put it bluntly, the reasons that the WSJ article pooh-poohs (the rise of online brokerages, decimalization, Eliot Spitzer’s moderately successful crusade to turn Wall Street into a giant smoking crater), in conjunction with the reason it holds on a pedestal (Sarbanes-Oxley), do a pretty good job of describing why the IPO market looks the way it looks.

That unignorable history (unless you’re the Wall Street Journal) looks roughly like this:

1. 1996-1997, the rise of DIY online brokerages: Starting with Charles Schwab in 1996 and moving on to E*Trade and others, online brokerages began undercutting the traditional brokerage house fees by an order of magnitude. Trades could be had for ~$20 instead of ~$200. And with the decline of the traditional brokerage model came the end of competition between firms to have the best stock picks based on the best (or least the most well-funded) research. The Bubble did a good job of masking this, but as the traditional brokers disappeared, so did some of the money going into small cap stocks.
2. 2001, SEC introduces decimalization: Stocks used to be traded in fractions, so there was a spread between the bid and the offer. SEC shifted to decimals (pennies) in order to lower the pricing and make trading easier to understand for consumers. It certainly did this, but it also disincentivized the brokers and defunded research.
3. 2002, Sarbanes Oxley: As we discussed above, this made it a lot more expensive and time-consuming to take your company public.
4. 2003, The Global Research Settlement: Eliot Spitzer imposes his phallus on Wall Street! As part of the Settlement, 10 of the largest securities firms “agreed”, in conjunction with the exchanges, to insulate their banking sections from their research sections. This ended the tradition of investment banks paying their research analysts from investment banking fees. Once again, this helped kill support for small cap stocks.

These are the main landmarks, but there’s a whole host of other factors that helped contribute to the trend. How the WSJ can look at this history and claim that Sarbanes-Oxley was the precipitating event in this trajectory, or that it can somehow be divorced from its regulatory antecedents and blamed for the lame IPO market is beyond me.

And, if you think that the stuff that happened before Sarbanes-Oxley has contributed as much or more to the lack of IPOs, your outlook on the likelihood of a mid-90s-style revival should be pretty grim. This graph does a good job of showing the decline of small cap IPOs well in advance of Sarbanes-Oxley.

Does it matter?/What to do?

I pose “does it matter?” as a question, but it’s one with a pretty obvious answer. Yes, it matters, especially to entrepreneurs, but also to VCs, who have seen the length of time from incorporation to IPO creep steadily upward. The average used to be around 5 years. We’re nearly at the point that the average period is nearly the same as the duration of most VC funds. It should be self-evident that this is bad for everybody involved, although I would argue (maybe in another post) that the rise of secondary markets should cushion the blow both to companies and VCs.

The NVCA released a report 2 years ago that described the rather dire state of affairs and recommended a 4-Pillar Plan To Restore Liquidity in the US VC Industry. The 4 Pillars (one wonders whether there was a 5th that was scuttled after an NVCA intern discovered the 5 Pillars of Islam and was worried about the SEO implications) are:

• Ecosystem Partners:

Within the last decade, venture-backed companies have been faced with fewer choices as it relates to investment banks and accounting firms that will assist in the IPO process. While the major investment banks continue to operate, the “four horsemen” boutique investment banks of the 1990’s (Alex Brown, Hambrecht & Quist, Montgomery Securities, and Robertson Stephens), which specialized in IPOs of venture-backed companies, no longer exist. Further, the fall of Arthur Andersen and the resulting pressure placed on the Big Four accounting firms has, in many markets, left a void in terms of quality auditing services available for these smaller companies.

Against this backdrop, the NVCA believes that the venture capital industry must do more to promote alternative ecosystem partners while engaging with existing members to identify ways to better serve the needs of emerging growth companies. The Association has begun to engage in talks with boutique and major investment banks as well as the Big Four and other public accounting firms about how they can also better serve the needs of small cap companies. The NVCA also intends to encourage the use of a broader array of service providers such as the “Global Six” including Deloitte LLP, Ernst & Young LLP, Grant Thornton LLP, KPMG LLP, PricewaterhouseCoopers LLP and BDO Seidman LLP.

• Enhanced Liquidity Paths:

There is consensus among many within the capital markets ecosystem that the distribution system that connects sellers and buyers of venture-backed company new issues is broken. There are many drivers behind this disconnect including mismatched expectations in terms of issue size, the lack of sell side analysts, and the propensity of hedge funds to buy and sell stock quickly. All of these factors contribute to a lack of an adequate distribution channel and considerable post-IPO market volatility.

To offer small venture-backed companies an enhanced distribution system for the sale of initial stock, the NVCA endorses concepts such as Inside Venture which is a private market platform that connects qualified companies that intend to IPO within 18 months with pre-screened cross-over investors. These buyers commit to buy and hold these stocks for the long term. Other providers with similar models include Portal Alliance (NASDAQ), SecondMarket and Xchange. Additionally, the NVCA will help raise awareness about pro-active M&A roll up strategies of smaller portfolio companies to achieve IPO critical mass and global alternatives to the U.S. public markets.

• Tax Incentives

The NVCA has long asserted that the government must support a tax structure that fosters capital formation and rewards long term measured risk taking. To support a more vibrant IPO market, the U.S. must maintain tax policies that have been proven to encourage venture capital investment so that the pipeline of promising IPOs is as robust as possible. Further, Congress should consider adopting new tax incentives which would stimulate IPOs, at least in the short term.

The NVCA will continue to advocate strongly for a capital gains tax rate that is globally competitive and preserves a meaningful differential from the ordinary income rate. The Association asserts that venture capitalists who are successful in building new companies should continue to be taxed at a capital gains rate for any carried interest that is earned over the long term. The Association also intends to explore the possibility of a one time tax incentive for buyers and holders of IPOs as well as increasing the holding rate for capital gains status to two or more years.

• Regulatory Review

From a regulatory perspective, the last decade has been characterized by a series of broad sweeping regulations aimed at curbing serious abuses within the financial system but fraught with unintended consequences for small pre-public and public companies. From Sarbanes Oxley (SOX) to the Global Settlement to Reg FD, small venture-backed companies have been faced with costly compliance and increasing obstacles to enter the public markets as a result of regulations intended for larger multi-national corporations. The NVCA strongly supports regulation and protecting investors where necessary but does not support a uot;one-size-fits-all” regulatory approach.

To wit, the NVCA will advocate for a full systematic review by the Securities and Exchange Commission of recent regulations which impact small cap companies. This review would include interpretations of SOX, pre-IPO financial reporting requirements, the separation of analyst and investment banking functions, and private placement requirements. There are opportunities within existing regulations to tier compliance so as not to overburden emerging growth pre-public and public companies at a time when they need support from the government, their auditors, and the markets.

[-ed: Sorry about the excessive C&P, but I thought that full, in-line descriptions of the Pillars might be preferable to a link. This is what my vast readership has told me in the past.]

The most interesting part of the NVCA prescription for me is Pillar #2 and the mention of secondary markets. Private trading on secondary markets, it seems to me, provides a pretty compelling remedy, especially for entrepreneurs looking for funding to bridge that period between the old school 5-year IPO timeline and the new world order of 7 -10 years. This may even prevent companies from going public before they’re ready or from selling to a larger company with unsatisfactory conditions (valuation, earn outs, etc.). All the while, these secondary markets should allow companies to reap many of the benefits of going public referenced at the beginning of the post without many of the drawbacks. Secondary markets often allow companies to reveal far less information than they would have to if they were issuing an IPO and they’re far less costly. I’ve seen estimates of the cost of going public that range from 10-20% of the total valuation for legal, accounting, underwriting services.

I don’t have enough experience or knowledge of the VC industry to know whether secondary markets in conjunction with non-IPO exits are going to be enough to keep the industry funded at levels that will promote growth and innovation. I suspect that the answer is no, and that industries that are traditionally more reliant on IPOs, or industries in which the universe of potential strategic buyers is smaller or less obvious, may suffer from narrowed funding options and more skeptical investors. And in the comments section of Primack’s piece, VC Jeff Bussgang makes a few observations about the relationship between the M&A and IPO markets that should make us worry about the health of the ecosystem without a robust IPO market:

Dan – I rarely disagree with you (and I almost always disagree with the WSJ editorial pages) but I think you’re wrong on this one.

First, VCs need a strong IPO market to generate strong exits alongside the M&A market. If the IPO market is strong, then it’s a credible threat that provides leverage when negotiating with acquirors. I have seen many situations where a company will file to go public and then get bought at a healthy price because it’s such a strong financing and liquidity path (e.g., Gomez – Compuware).

2) Lean start-ups are great for the initial days when searching for product-market fit, but once a company gets north of $10-20 million in revenue, there comes a time to abandon lean and begin to invest in growth – a broader product footprint, global distribution and world domination. Having a high potential path to an IPO generates M&A interest for everyone in the ecosystem. Many scale revenue companies (say, $50-100 million) are hunting around to bulk up to build up enough critical mass to go public. Online video leader Tremor’s acquisition of ScanScout and Transpera is an example here.

3) Yes, the IPO market has gotten better, thankfully, but the barriers are still high. Many of these companies are very large entities or foreign companies (e.g., Chinese-based IPOs have been very fashionable lately). Talk to medium-scale company CEOs and investment bankers and you’ll hear the same thing – it’s hard, expensive and daunting to take a company public.

We should all be fighting to make it easier. Even if that means (gulp) agreeing with the WSJ editorial pages..