Sorry, But Who You Know Still Matters

We live in an age where “democratization” is all the rage in the world of startup investing. An age where rent-seeking gatekeepers such as venture capitalists are going to be put out of business by Crowdfunding, ICOs, and more generally the mass dissemination of information across the world via the internet. Pretty soon, so the narrative reads, everyone will have access to the best deals, and a new entrepreneurial golden age will emerge. The only thing that will matter is what you know, and John and Jane Doe will be driving the Tesla’s previously consigned to the folks on Sand Hill Road.

Baloney.

The problem with the notions that “everyone will have access to the best deals” and “everyone will be empowered to make the best deals” is that neither assertion is true.

On the first score, the people with the best deals will continue to seek out the investors with the best track records and value-add. I mean, if you are really good and have a really good idea, who would you rather have financing your start-up, Sequoia or some guy named Barney and his pals at the country club in Podunk?

As for the second point, evaluating, making, and managing the best deals is about more than having access to them: it is about having the skills, experience, and networks to recognize them and turn opportunity into achievement. Good venture investors are in fact good at something that is very hard to be good at, not something any old Jane Doe could master if only she had access to the same raw material (most if it garbage in any event). Seriously, pick a name out of the phone book and the chances you’ll find a really good high impact venture investing talent is probably about the same as your finding someone who can hit a major league curveball.

I am not arguing that Crowdfunding and ICOs and the internet generally have not changed and will not continue to change the venture capital business. What I am arguing is that those changes will be evolutionary more than revolutionary; that the fundamentals, including the curation of deal flow, will still be very much in play. And that curation will continue to be one of those “guilt by association” situations driven by relationships, not algorithms.

Look at it this way. Most venture investors see far more entrepreneurs and deals than they can possibly give serious attention to, much less invest in. Further, the best venture investors not only see the most deals generally, but the most good deals as well. There is an awful lot of noise in the system. And for pretty much every venture pro out there, the most logical and effective first noise reduction filter is… who that I respect thought this deal was worth my time to look at?

Deals where the answer to that question is “no one,” aka “over the transom” deals, seldom get more than the most cursory review, and as any honest VC with a solid track record will tell you almost never get done.

Will adding more over the transom deal flow – for example via web solicitation or on public Crowdfunding sites – change that? Of course not. An experienced VC will be no more likely to seriously investigate a deal that comes in over a digital transom than a deal that comes in over a traditional transom.

 

None of this means that Crowdfunding and ICOs and the internet generally are not changing the venture business. But the changes are around the margins – more efficient ways to distribute, access and process information. And these changes are lowering transaction costs, which is great for everyone. But as much as there is more noise in the system, the value of getting a curated introduction to a good investor is if anything more, not less, valuable than it was in the past.

And so, discounting the hype and the bad actors in the Crowdfunding and ICO worlds, the large majority of the good deals are mostly being done by professional investors in closed – even if online – syndicates. And by teams that meet their lead investors via an introduction (likely as not a digital one), not the online equivalent of a billboard.

The point, then, is this: if you are serious about getting your start-up funded by investors that know what they are doing, start talking to folks – other entrepreneurs, service providers, other investors – that are known and respected by those folks. Because no matter how much you know, who you know still matters.

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Startup Valuation on the Back of an Envelope

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, a Milwaukee Journal Sentinel blog covering start-ups and other Wisconsin technology news. Paul’s most recently contributed piece, “Startup Valuation on the Back of an Envelope” can be found under their Business Tab in the Business Blog section: Click here to view his latest blog.

A short excerpt can be found below:

“Over the years, I’ve developed a deck of slides and some related spreadsheets walking through how venture investors think about valuing startups.

I’ve given the talk to dozens of audiences mostly consisting of entrepreneurs and angel investors. It usually takes about an hour. Recently, I was asked to cover the subject in about ten minutes. Honestly, my first thought was that it couldn’t be done.

But then, as most entrepreneurs discover early on, necessity proved the mother of invention. So, if you are looking for the basics – just the bottom line, actually – on startup valuation here it is.”

Click here to read more.

Thinking About Financing Rounds

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 “Thinking About Financing Rounds” can be found under their Business Tab in the Business Blog section. Click here to view his latest blog.

Here is a short excerpt:

Most high impact entrepreneurs need capital to build their businesses. The amount of capital, and the timing of the infusion(s), is mostly a function of the kind of business/business model and the time it takes to get home – that is to an exit transaction. So, for example, an entrepreneur who happens to be a programming wizard with a simple, niche mobile app might need say $10,000 to develop, validate and sell his app/business for several million dollars in say 12 months (the assumptions here being that the app is in fact something that the market wants, and the execution by the entrepreneur is outstanding). At the other end of the spectrum, a scientist with an idea for a new drug for treating cancer will likely require several hundred million dollars or more and ten years to see that that idea turn into an FDA approved drug. Further complicating matters, the exit strategy, more particularly whether the goal is a relatively modest exit sooner rather than later, or a more substantial exit of a more mature company, has a big impact on how an entrepreneur thinks about rounds of financing.

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.

A Skeptic’s Take on Crowdfunding

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 contributed piece “A Skeptic’s Take on Crowdfunding” can be found under their Business Tab in the Business Blog section. Click here to view his latest blog.

Here is a short excerpt:  “Crowdfunding – for my purposes today the sale of equity by early stage high risk/impact businesses via general solicitations of investors, as for example over the internet – is probably the biggest thing to come along on the startup financing landscape since the 1933 Securities Act. While the final rules are still playing out, it is already clear that crowdfunding is rapidly emerging as a viable alternative for raising startup capital. Lots of folks think that crowdfunding will bring enormous new pools of capital to the startup financing business, benefiting capital starved entrepreneurs and investors previously locked out of the startup financing game alike. Praise be your preferred Deity.

Count me, though, as skeptical. Not that crowdfunding won’t produce some good deals that might otherwise not find their footing, but rather that crowdfunding will have a significant positive and durable impact on the risk capital environment for quality high impact startup businesses. My sense is that when all is said and done, in terms of the preferred financing strategies for the higher quality early stage startups, crowdfunding will produce a lot more smoke than fire.”

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.

Thoughts on Why Good Venture Investors Turn Down Good Deals

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 “Thoughts on Why Good Venture Investors Turn Down Good Deals”  can be found under their Business Tab in the Business Blog section. Click here to view his latest blog.

Here is a short excerpt:

If you know anything about venture capital investing, you probably know that most plans that come across the desks of venture capitalists (and angels, for that matter) are not fundable. That is, they are of so little merit that no half-way competent investor would back them at any price.

While lots of plans get rejected because they are frankly bad, in my own experience as an entrepreneur, angel and institutional venture capitalist I have been struck by how many fundable deals get turned down by so many competent investors. (If you don’t believe me check out http://www.bvp.com/portfolio/antiportfolio, where Bessemer Ventures reviews some of the ultimately hugely successful deals that they turned down over the years.) Herewith some of the reasons good venture investors turn down good deals. 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.

 

An Introduction to Revenue Participation Financing

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 “An Introduction to Revenue Participation Financing” can be found under their Business Tab in the Business Blog section. Click here to view his latest blog.

Here is a short excerpt: “In a Revenue Participation financing a business (let’s call it Newco) offers an investor (Investor) a percentage of Newco’s future gross revenues in exchange for a capital investment. In its simplest form, Newco offers to give Investor y% of future gross revenues until such time as Investor has been paid “x” times the amount of capital invested. So, for example, in exchange for $100,000 of capital, Newco could agree to pay Investor 20% of future gross revenues until Newco has paid Investor 3x the $100,000 capital investment, or $300,000.” 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.

 

Partially Participating Preferred: An Alternative to Participation Caps

By: Paul A. Jones

In an earlier blog (Capping Preferred Participation: A Compromised Compromise), I argued that the usual middle ground between entrepreneur-friendly “non-participating” preferred stock and investor-friendly “participating” preferred stock – capping participation at some multiple of an investor’s base preference – is seriously flawed. Herewith an alternative approach.

By way of a quick refresh, we are talking about “participation” in the context of a preferred stock liquidation preference. In an exit transaction, other than an IPO, an investor holding “participating” preferred shares gets two bites at the exit proceeds apple. First, a bite equal to his base preference (typically an amount equal to his investment) and then a second bite equal to his pro-rata share of the remaining exit proceeds.

An example: An investor who put down $1 million for a 40% ownership position in Newco in the form of “participating” preferred shares would, in the event Newco was sold for $3 million, receive $1 million “off the top” and in addition 40% of the remaining $2 million of proceeds for a total of $1.8 million. That means the investor, who owned 40% of Newco when it was sold, would get 60% of the exit proceeds. If instead, the investor held “non-participating” preferred shares he would receive either (i) his $1 million base preference or (ii) his 40% pro-rata share of the $3 million or $1.2 million.  Clearly, the investor would take the $1.2 million pro-rata share and leave the entrepreneur with $600,000 more money than he would have had if the investor had held participating preferred.

Looking at the above example, it is not hard to see why entrepreneurs don’t like participation and investors do. While the relative impact of the participation right diminishes as the exit proceeds rise (in the example, the difference is always $600,000), at every exit that leaves anything for the common shares, the investor with participating preferred gets more and the entrepreneur less.

In light of the above, entrepreneurs and investors long ago came up with a compromise on the participating/non-participating issue, the so-called “participation cap.” As with non-participating preferred, “capped” participating preferred gives an investor a choice. When exit proceeds are being distributed, the investor can choose to take either his pro-rata share of the proceeds (his percentage ownership at the exit) or his base preference plus participation in the distribution of the remaining proceeds until he has received in the aggregate an amount up to some multiple – say 2x or 3x etc. – of his base preference.

Now at first glance, capped participation seems like a reasonable compromise on the participation/non-participation negotiation. As my earlier blog pointed out however, it is a compromised compromise. The problem (if you don’t want to go back and review the prior blog, just trust me on this) is that when you cap the participation preference, you create a situation where there is range of exit proceeds (a “zone of indifference”) where an investor doesn’t care what the exit proceeds are. In the example in the earlier blog, the investor got the same payout ($4.5 million) for exit proceeds anywhere between $6 million and $9 million. Faced with a deal that promised $6 million in exit proceeds, the investor would have no incentive to negotiate for a higher price unless he thought he could get the price up at least to $9 million plus one dollar. In which case the investor would get a fraction of that final dollar. A savvy entrepreneur should be skeptical of an arrangement where an investor was indifferent over how much money the company was sold for over a significant range of plausible exit scenarios.

Fortunately, there is a better compromise, to wit “partial participation.” In this compromise, the entrepreneur and investor agree that the investor’s “second bite” at the proceeds apple will be some fraction of the investor’s pro-rata ownership share. For example, that fraction might be one-half. Going back to our initial example where the investor has invested $1.0 million for a 40% ownership interest and the exit proceeds amounted to $3 million, the investor would first get his base preference ($1 million) and then get an additional $400,000 (one-half of 40% of the remaining proceeds). The “second bite” would be worth exactly one-half of what it would be worth if the investor had full participation. If the partial participation fraction was set at one-quarter, the “second bite” would be worth exactly one-quarter what it would be worth compared to full participation, and so on. (For readers interested in playing with the numbers, click here.)

Compared to capped participation, partial participation is much easier to understand. The compromise consists of picking a fraction between 0 and 1, which such fraction perfectly represents the way the compromise plays out as a fraction of full participation. Even more important, partial participation has another big advantage over capped participation: there is no zone of indifference. There is no range of exit prices where the investor is anything less than fully incented to work with the entrepreneur to negotiate a better price. And that makes partial participation a better participation compromise.