Back to the Future in Silicon Valley

Silicon Valley came by its name honestly enough: way back in the 60s, 70s and 80s, it was the place where venture capitalists and entrepreneurs turned silicon into computer chips in high volumes and at low prices that astonished the world. I have a chart on my office wall that shows how hundreds of silicon-based chip companies emerged in the Valley in that period, the vast majority of which could be traced to Shockley Semiconductor Laboratory (founded 1956), and Fairchild not long thereafter – the later spawned so many later chip companies that it fairly earned the moniker “Fairchild University.”

The Big Kahuna of the silicon companies in Silicon Valley was and is, of course, Intel.  The company’s x86 chip architecture, launched in 1978, powered the PC revolution and remains to this day by far the dominant architecture in personal computers, laptops, workstations, and even the cloud computing business. It’s even a big player in the supercomputer segment. Name a big chip company and chances are good a big part of its business is x86-based chips. Much the same as the IBM System/360 architecture has dominated the mainframe business since the 1960s. Yes, there is still a market, albeit not so big as it used to be, for mainframes.

The x86 architecture has been so dominant for so long that for maybe the last two decades or so, the venture capital business – a business that owes its current form largely to its role financing all those chip companies way back when – has pretty much stopped funding chip startups. Until recently, that is.

I was doing a bit of research on the current AI revolution (there have been others: folks of a certain age will remember the “expert systems” AI hype in the late 80s) when I found something pretty interesting – well, to me, at least. Over the last couple of years, VCs have invested hundreds of millions of dollars in more than 20 new chip companies. All of which seem to have one thing in common: they are developing chips optimized for AI applications. Chips with non-x86 architectures.

I said I found this interesting. That’s because it suggests to me that while lots of folks are talking about how various tech-enabled and tech-driven revolutions are on the cusp of changing the world for people who use technology, and how to frame that as an investment opportunity, far fewer folks are talking about how those revolutions might change the world for today’s biggest producers of technology, and how to frame that as an investment opportunity. So, for example, while there are plenty of people talking about how AI might disrupt the smartphone business and the personal transportation space, not so many are talking about how AI might disrupt the businesses that provide the components that power those businesses. Who, that is, will be the next “Intel Inside.”

I’m betting it won’t be Intel – for the same reason IBM didn’t follow its System/360 mainframe architecture with something like an x86 architecture of its own. When you are king of a big mountain, and Intel’s is still sitting at the top of a pretty big one, you tend to think more about defense than offense. Protecting your realm, not cannibalizing it. Just ask Kodak – the folks who invented digital photography.

So here is an investment hypothesis: Assuming (and this is a big assumption) that today’s AI revolution will be even nearly as big as the hype suggests, I’ll bet when the dust settles there is a new sheriff in the silicon part of Silicon Valley. Though if you look at where those chip-hungry VC investors have been spending their money, it just might be an out-of-towner.

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The Cultural Roots of the Innovation Economy

Paul Jones, co-chair of Venture Best, the venture capital practice group at Michael Best, has been selected as a regular contributor of OnRamp Labs, the newest blog addition to the Milwaukee Journal Sentinel covering start-ups and other Wisconsin technology news.

Paul’s most recent contributed piece “The Cultural Roots of the Innovation Economy” can be found under their Business Tab in the Business Blog section. Click here to view his latest blog.

Here is a short excerpt: “Silicon Valley has been the center of the venture capital and high impact entrepreneurship world for so long that most people under say sixty or so don’t realize that it wasn’t always so. Way back when I was a kid (I was born in 1958) what we now call Silicon Valley was mostly known, if at all, for its orchards. Boston and the adjacent Route 128 region was the birthplace of the modern venture capital industry, and reigned supreme as, well, the Silicon Valley of the day.” Click here to read more of Paul Jones’ OnRamp Labs blog post located under the Business tab of the Milwaukee Journal Sentinel’s website, www.jsonline.com.

UW-Madison Technology Commercialization Efforts

Michael Best’s Paul Jones, co-chair of the Venture Best Practice Group, was quoted in today’s Milwaukee Journal Sentinel on the recent technology commercialization efforts at the University of Wisconsin-Madison.

UW-Madison Chancellor Rebecca Blank is leading a new university-driven commercialization effort called, Discovery to Product (D2P). D2P is an initiative intended to provide UW–Madison faculty and students with an easy-to-access gateway to a comprehensive suite of resources to help transform ideas and discovery into companies and products to bolster Wisconsin’s economy. In the article, Jones brings to light what business investors can bring to the table beyond the campus borders.  Click here to read the article or watch the D2P Initiative Announcement video below.

There’s an App for That: FDA Issues Final Guidance on Mobile Medical Apps

By: Seth A. Mailhot

The U.S. Food and Drug Administration (FDA) issued a final guidance September 25, 2013 titled, “Mobile Medical Applications.” The guidance sets out the scope of FDA’s enforcement discretion on medical software applications designed for mobile devices. The final guidance follows up on a draft guidance issued on July 21, 2011, and is intended to provide even more predictability and clarity for manufacturers of mobile medical apps. The final guidance provides further examples of the types of mobile medical apps to be regulated (and not regulated) by FDA. FDA has planned a Twitter chat to discuss the new guidance on September 26 at 3:30 p.m.

Much of the guidance reiterates or restates the longstanding policy set out by FDA on the regulation of software as a medical device. For example, as noted in the guidance, “when stand-alone software is used to analyze medical device data, it has traditionally been regulated as an accessory to a medical device or as medical device software.” The regulatory policy set out in the guidance applies a risk based approach to mobile medical apps. As stated in the guidance, “certain mobile medical apps can pose potential risks to public health. Moreover, certain mobile medical apps may pose risks that are unique to the characteristics of the platform on which the mobile medical app is run. . . .FDA intends to take these risks into account in assessing the appropriate regulatory oversight for these products.”

One important point to note is that with the expansion in portable computing power, almost any medical software application that operates on a current off-the-shelf operating system may be viewed as a mobile medical app subject to the guidance. According to the guidance, “mobile platforms are defined as commercial off-the-shelf (COTS) computing platforms, with or without wireless connectivity, that are handheld in nature. Examples of these mobile platforms include mobile computers such as smart phones, tablet computers, or other portable computers.” While the guidance refers to “desktops” as being distinct from “mobile platforms,” the guidance does not distinguish software that may operate on both a desktop and a mobile platform due to a shared operating system.

The definition of a mobile platform is actually a departure from the draft guidance, which adhered more closely to what would typically be considered a “mobile platform.” In the draft guidance, the definition included as examples, “the iPhone®, BlackBerry® phones, Android® phones, tablet computers, or other computers that are typically used as smart phones or personal digital assistants (PDAs).” While computing technology has advanced, expanding the definition to contemplate notebooks and other slim-profile computers adds a certain layer of confusion to the guidance.

The final guidance restates and expands the policy from the draft guidance on the entities that qualify, and do not qualify, as mobile medical app manufacturers. For example, developers that create a mobile medical app based on specifications from an “author” do not qualify as a manufacturer subject to FDA regulation. Content distributors, such as the owners and operators of “Google play,” “iTunes App store,” and “BlackBerry App World,” also are not held to be mobile medical app manufacturers. The final guidance, however, fails to address what responsibility such content distributors might have in terms of complaint handling and recalls, given the control such content distributors exert over the distribution system for mobile devices1.

FDA did note that entities that distribute their mobile medical app software as a service, such as through a web-based subscription, do qualify as manufacturers. Note that this does not mean that FDA is extending into the regulation of services distributed through web-based software applications, only that the software distributed under this model would be subject to FDA regulation.

The core policy articulated in the guidance is the categories of medical software that are considered mobile medical apps, and those that are subject to enforcement discretion by FDA. FDA identifies three categories that the agency considers to be mobile medical apps:

  1. Mobile apps that are an extension of one or more medical devices by connecting to such device(s) for purposes of controlling the device(s) or displaying, storing, analyzing, or transmitting patient-specific medical device data.
  1. Mobile apps that transform the mobile platform into a regulated medical device by using attachments, display screens, or sensors or by including functionalities similar to those of currently regulated medical devices. Mobile apps that use attachments, display screens, sensors or other such similar components to transform a mobile      platform into a regulated medical device are required to comply with the device classification associated with the transformed platform.
  1. Mobile apps that become a regulated medical device (software) by performing patient-specific analysis and providing patient-specific diagnosis, or treatment recommendations. These types of mobile medical apps are similar to or perform the same function as those types of software devices that have been previously cleared or approved.

FDA also outlines six general categories of medical software that are subject to enforcement discretion:

  1. Mobile apps that provide or facilitate supplemental clinical care, by coaching or prompting, to help patients manage their health in their daily environment.
  1. Mobile apps that provide patients with simple tools to organize and track their health information.
  1. Mobile apps that provide easy access to information related to patients’ health conditions or treatments (beyond providing an electronic “copy” of a medical reference).
  1. Mobile apps that are specifically marketed to help patients document, show, or communicate to providers potential medical conditions.
  1. Mobile apps that perform simple calculations routinely used in clinical practice.
  1. Mobile apps that enable individuals to interact with PHR systems or EHR systems.

In particular, FDA expanded the types of medical imaging software that would be exempt from FDA regulation. The previous draft guidance suggested that using a magnifying function for a specific medical purpose would make the software a regulated medical device. This left the impression that using any camera or light source native to a mobile platform for a specific medical purpose might be regulated by FDA. FDA clarified that “utiliz[ing] the mobile device’s built-in camera or a connected camera for purposes of documenting or transmitting pictures (e.g., photos of a patient’s skin lesions or wounds) to supplement or augment what would otherwise be a verbal description in a consultation between healthcare providers or between healthcare providers and patients/caregivers” would not be regulated by FDA as a mobile medical app.

FDA also provided specific clinical calculations that would be exempt from FDA regulation as a medical device:

  • Body Mass Index (BMI)
  • Total Body Water / Urea Volume of Distribution or Mean arterial pressure
  • Glascow Coma Scale score
  • APGAR score
  • NIH Stroke Scale
  • Delivery date estimator

Although the guidance ostensibly deals with mobile medical apps, the policy statements on what medical software qualifies for FDA regulation may also be applied to medical software designed for desktop platforms, as the underlying basis for many of the positions articulated by FDA are founded upon longstanding polices on medical software. The issuance of this guidance provides companies with an opportunity to review product offerings to confirm whether their medical software products meet the threshold for FDA regulation. Michael Best can assist medical software companies with this review, and can advise on how to meet FDA’s regulatory requirements for mobile medical apps. Michael Best has experience with medical software submissions to FDA, and the role that the software design control process plays in FDA’s regulation of medical software.

1 This was an issue carried over from the draft guidance. FDA suggests that these content distributors “do not engage in any manufacturing functions as defined in 21 CFR Parts 803, 806, 807, and 820,” but overlooks the pervasive control some content distributors have over software updates and complaint reporting.

Understanding the Limits of Convertible Debt Seed Financing Structures

By: Paul A. Jones

While convertible debt with a “kicker” of some sort (typically either in the form of warrants or a discount on the conversion price) was first used primarily as a structure for bridging companies between rounds of traditional venture capital financing, more recently it has become a popular vehicle for seed financing in advance of the first (A) round of venture investment. The structure offers two major plusses for entrepreneurs and investors. First, it postpones the valuation negotiation until both parties have a better handle on the key variables. Second it is faster and cheaper to implement than a formal Series A round.

That said, like most ideas that have been around for a while, convertible debt has found its way into more situations where it may not be a very good fit. Today, my focus is exploring the situational limits of the convertible debt financing structure in the startup context.

Conceptually, the convertible debt structure works when an entrepreneur seeks a modest round of risk capital to achieve a significant milestone in a short period of time, the accomplishment of which will set the stage for a substantially larger subsequent A round of financing. Framed this way, the terms “modest” and “substantially” are linked, while the terms “significant” and “short” are more or less independent.

Let’s start, then, with the “modest” and “substantially” discussion. Essentially, the notion here is that the bigger the difference between the seed round need and the A round need, the more a convertible debt structure makes sense. Depending on the kind of deal (think bigger in capital intensive businesses) and the seed capital market (think bigger in venture capital centers) a convertible debt seed round might be anywhere from $5k to $1 million or more. The critical point is that the expected A round be substantially larger. How much is that? In general, the A round should be at least 2x and ideally 3x or more the size of the seed round.

The reason the A round should be at least twice the size of the seed round is that if the seed round gets much bigger, the impact of the seed round kicker on the A round valuation negotiation will at some point cross the fuzzy line from marginal (and thus largely overlooked) to central (and thus problematic). For example, consider a $500k convertible note with a 20% discount on conversion. If the subsequent A round is a $5 million raise, the seed round kicker (basically, the seed folks will get an extra $100k worth of A round stock) represents roughly 2% of additional dilution to the A round investors. In theory the A round investors might factor that 2% into the A round valuation discussion. In practice, probably not.

On the other hand, if the A round in the above example is just $1 million, the overhang from the 20% kicker looms much larger. In fact, it now represents roughly an additional 10% dilution to the A round investor. At this point, what was a theoretical issue for the A round investors, in terms of the valuation negotiation, might be a practical issue as well. As such, it will likely complicate the A round valuation discussion, and likely result in a lower A round valuation – and corresponding additional dilution for the entrepreneur. (Alternatively, some or all of the additional dilution might be shared with the seed round investors, if they can be persuaded to waive some or all of the seed round kicker.)

Let’s turn now to the significant milestone variable in the seed convertible debt scenario. What constitutes a significant milestone? Essentially, two related concepts play into what constitutes a significant milestone. The more central of the two is the notion that significance is measured by how much risk the accomplishment of the milestone takes out of the deal. Particularly at the early stages of a high impact business, the primary driver of value is risk reduction. The seed milestone should be well-defined, and the accomplishment thereof should reduce the risk that the deal will get to a satisfying exit by, say, 25% to 50%. (That might seem like a lot, but really it just reflects how risky high impact entrepreneurship really is.) In addition, though in fact another way of framing pretty much the same issue, the accomplishment of the seed milestone should provide a much firmer foundation for the valuation discussion at the A round.

In my own world, I see a lot of web-centric startups where the seed round milestone is the delivery of the proverbial minimally viable product coupled with some modest customer validation. The significance of the same – the transformation of the entrepreneur’s idea into an actual product that at least a handful of folks in the target market will buy – is pretty obvious, both in terms of risk reduction and firming up the A round valuation parameters.

Finally, let’s consider the short time variable in the seed convertible debt scenario. This is in some ways the trickiest variable because it doesn’t so much depend on the practical demands of the convertible debt structure as the extant market dynamics. By that I mean that the bounds of the time variable are more a function of the market’s determination that an acceptable seed round kicker is something between 10% and 30% than any conceptual limits on the amount of time expected between the seed round and the A round. The notion here is that the seed round investors will accept a relatively modest 10% to 30% kicker on the assumption that the return will be over a reasonable period of time.

What is reasonable? In my experience, no more than 18 months, and generally less than 12 months. Why? Because if the implicit rate of return on the seed debt falls too far below the expected A round return (which might eye-ball at something like 100% from A round to B round) the seed round investors will quite rightly wonder whether their generosity in providing seed capital with only a modest kicker has crossed into philanthropic territory. And while I have known a lot of seed investors who think giving back some of their own good fortune by supporting the next generation of entrepreneurs is a wonderful thing, I have not found many who think giving away their good fortune to a next generation entrepreneur is a good thing.

The Venture Capital Valuation Paradox

By: Paul A. Jones 

Question:  A Venture Capitalist pays $1 million for 1 million shares of convertible preferred stock laden with special rights and protections (including the right to convert into shares of common stock one-for-one at the VC’s option).  The company also has 2 million shares of common stock outstanding.  What is the pre- and post-money valuation of the company?

If you answered $2 million pre-money and $3 million post-money you can pat yourself on the back.  The investor paid $1 million for one-third ownership, and three times $1 million is $3 million.  Venture Capital 101 stuff.

But wait a minute.  Take another look, and ask yourself this: if the preferred stock is convertible any time into common stock one-for-one; comes with a lot of value-added goodies; and is worth $1.00/share, how much is the common stock worth?  If you answered “something less than $1.00/share” (how much less is good topic for another blog), pat yourself on the back again.

Except, if there are 1 million shares of preferred outstanding worth $1.00/share, and 2 million shares of common outstanding worth something less than $1.00 share, the value off all the stock outstanding is … something less than $3 million – which is to say less than the $3 million post money valuation that we learned about in VC 101.

So we have the venture capital valuation paradox.  How can everyone agree that the post-money valuation is $3 million and at the same time agree that the value of all of the stock of the company is worth something less than $3 million (probably something like $2 million, though again, that is a subject for another blog)?

Okay, let’s cut to the chase.  The “correct” answer, for accounting purposes, in terms of the value of a company owned by its shareholders is the aggregate value of all of the shares of stock outstanding. This, in our example, is something less than $3 million.  That said, both the entrepreneur and the VC in our example will continue to think in terms of a $3 million post money valuation.  Perhaps they are less than accomplished accountants?  Or are they just plain stubborn?  Or is something else going on, something more important (don’t tell this to your CPA) than GAAP (generally accepted accounting principles).

What gives here is the notion that while accountants think in terms of what a deal is actually worth at a specific point in time, in the context of the close of a venture capital financing, entrepreneurs and venture capital investors think in terms of what a deal is worth assuming that it ultimately “works.”   That is, assuming that the company will ultimately achieve an exit at a price significantly higher than the price last paid for the preferred stock.  In this case, all of the preferred stock will convert into common stock – and thus, ultimately, be worth what the common stock is worth, or $1.00 per share as of the closing of the instant financing. This equates to a post-money deal valuation of $3.0 million.

The analysis is not very elegant, and is perhaps even arbitrary.  But that’s the way everyone (everyone but the accountants, at least) keeps score in the venture business.

The Good Angel Investor (Part 2): After the Closing

By: Paul A. Jones 

In Part 1 of this post, I focused on issues entrepreneurs and angels should think about as a seed deal comes together. Today, I want to focus on how angels can engage with entrepreneurs after the money changes hands.

Foremost among post-closing advice for angel investors is this: never forget that as an angel investor, you are a coach, not an athlete. Many angel investors have been successful entrepreneurs themselves and one of the “value adds” that these angels can bring to a startup is the benefit of their own entrepreneurial and management experience. But good angels understand that their role is to give counsel, not orders. Few things make for a more unhappy and usually dysfunctional angel/entrepreneur relationship than an angel who thinks he is, or should be, making decisions rather than offering advice and counsel.

Good angels also remember that the business plan they invested in will likely change quite a bit, and often within months, or even weeks, of the closing date; “Pivoting” is the nature of the high impact startup beast. If you are skittish about major changes in direction based on less than complete information, high impact angel investing is probably not for you. Once in a deal, your thoughts and perspectives on pivots should be shared with the entrepreneur, but always with the caveat that that the entrepreneur should make the call.

Expanding on the pivoting theme, angel investors in early stage high impact startups should remember that mistakes will be made, most likely quite a number of them, as a startup matures. In more traditional businesses, the first thing that happens when a mistake is discovered is usually a search for someone to blame. Later on, after the appropriate parties are duly punished and steps are taken to reduce the risk of future mistakes, the focus shifts to correcting the mistake.

At high impact startups, mistakes are thought of more as learning opportunities than career killers. Entrepreneurs that don’t make mistakes are likely not sufficiently pushing the envelope, and entrepreneurs who don’t promptly learn from mistakes and move on seldom find much success. The angel investor’s role in all of this is to hold entrepreneurs accountable for mistakes, that is for timely recognizing and learning/recovering from those mistakes. Angels who take the more traditional approach of assessing blame and punishing the malfeasors simply waste resources, undermine entrepreneurial confidence, and discourage prompt recognition of mistakes going forward.

Taking a “let’s learn from this and move on” approach to entrepreneurial mistakes is important, but so is establishing a culture of accountability. Being supportive, even entrepreneur-friendly, does not imply passivity. Particularly for angels who are on the Board of Directors, being pro-active about regularly asking the hard questions about the business is a critical part of the job.  Think of it like this: as an active angel investor, it is your job to make sure that when the entrepreneur starts pitching new investors for the A round, she doesn’t get any questions you have not already asked. If she does, she should hold you accountable.

Finally, good angels understand that as the company grows, their role will decline, in most cases precipitously. Typically, the arrival of a solid lead investor for the A round marks the beginning of the end for the angel as a key member of the entrepreneur’s cabinet. Angels that want to stay as close to an entrepreneur as possible are wise to recognize this rather than fight it. Even angels that still have a lot to contribute are best served by moving off center stage, if only because that is ground the downstream investors understandably consider their own.