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From: "Curtis E. Sahakian" cpart2@corporate-partnering.com Ron, This follows up the recent exchange of email between me and Bob Geras. My original email was in the 01/02/2001 issue of the May report can
be viewed at http://alliancetalk.com/vc.htm
with direct links to the following sections Bob's response was in your 01/04/2001 issue. His second email on this subject was printed in your 01/12/2001 issue. Bob Geras and I talked after our initial exchange of emails. He is not a VC, but is an experienced angel investor and obviously a sincere person. I liked him. Still I can't let his emails go unanswered. This email, together with the links above, is a self validating crap detector. It's something your readers can save and use when someone starts laying down a smoke screen covering up what's really going on. To make things easy, let me start with a simple funding. An early stage company with a plan that needs $100,000 a month ($3.6M) of outside money over a period of 36 months in order to become self sustaining without further VC investment. Here are three possible ways it could be funded (the last is exaggerated): Scenario 1a (BAD!). The VC provides $1.8M and tells the founder to set his burn rate at $100,000 a month more than what his cash flow can support. At the end of 18 months the VC will make a judgement (entirely within his discretion) whether he has confidence in the venture's success and whether the venture still fits his investment criteria at that point in time. The VC decides whether and how much and at what valuation he will invest then... or whether to just delay negotiations and let the founder decide how close to the brink he will go before he does a drastic downsizing. Scenario 1b (BAD!). The VC says that he will provide $3.6M but will only contractually commit to the first $1.2M. If the venture meets its numbers with VC will then invest in the second tranche of $2.4M (of course this second round is entirely discretionary to the VC). Scenario 2 (GOOD!). The VC invests the entire $3.6M you ask for explaining that "I don't want to subject you to the risk and distraction of raising money at a critical point in time of your growth." Then goes on to say: (I) "Not only that, I want to invest an additional $1.4M to give you a safety cushion... because no matter how able you are, my experience tells me that you are predictably going to run into unexpected problems that will require more capital than you originally expected and I don't want you at the mercy of me or anyone else when that happens." (II) "We don't want to discriminate against you or your early investors (like your parents and relatives) so we won't demand series of a and b preferred stock with special rights that permit us to do just that... all we need is the same plan old common stock that you issued to them and yourself." (III) "I'm investing in you and your stewardship of the company, not vice versa, so I don't need any provisions that force you to spend my money the way I tell you to spend it, or which prevent you from altering your budget expenditures without my permission." And (IV) "I don't think it's fair for me to require you to pay me the attorney's fees I incur in negotiating my investment in your company, even if for some reason my lawyers become so unreasonable in the negotiations that you feel the need to break them off." STAGED INVESTMENT = DANGEROUS BURN RATES There is nothing inherently wrong with the staged investment approach represented by Scenario 1b. It is the most common form of VC investing (perhaps the only form of it). In my discussion with Bob Geras he confirmed he was a firm believer in this type of investing. In fact the very concept of being an angel investor is premised on the assumption of multiple rounds of funding (i.e. staged investment). Guess what, there is no difference between Scenario 1a and 1b. Let me say that one more time. There is no difference between Scenario 1a and 1b. If you look at scenario 1b, it is the very same high burn rate scenario we have been talking about all along. You know the one. The one where the founder is hung out to dry. That is... give the founder enough money to hang himself. If he doesn't hang himself the first time, do it again. Repeat that for rounds a, b, c, d, e, and f. If he survives that you have found yourself a winner. Both Scenario 1a and 1b are the same and all the successful VCs do it that way. Do they view themselves as harshly as I am portraying them? No. Do they understand the consequences of what they are doing? Of course they do. These are not slow witted people. Their own personal success and continued access to capital demands that they have a full and deep understanding of the cause and effect of their behavior and decisions. By the way, if you ever find a VC willing to fund you under Scenario 2... stop your search right then and there, ask him what he thinks is a fair valuation, shake his hand and then say "I accept." Then ask him how quickly he can draw up the papers. Unfortunately I don't believe such a VC exists. On second thought Scenario 2 is similar in many respects to my understanding of how Warren Buffet does his deals. And he does his deals with simple one page contracts instead of the standard "telephone book" VC agreements. Most VCs would claim that it would be suicide to do a Scenario 2 deal. Warren Buffet seems to do OK. HIGH BURN RATES = VENTURE CAPITAL The whole purpose of obtaining venture capital is to be able to temporarily sustain a high burn rate... a burn rate above which your customer revenue can not sustain. If you don't intend to spend at a burn rate above what your company can sustain with its own, you don't need venture capital and shouldn't be seeking it. In fact, if you don't need the venture capital to run a high burn rate, no reputable VC is likely to give it to you. They just aren't going to invest their money in your company to then have you stuff it away in a bank or trading account. If they wanted their money put to that use, they would do it themselves... better. Here is the REAL QUESTION for a founder looking for venture capital to sustain a high burn rate. Do you want it all up front? Or do you want to have to keep going back to the well each time asking "Mommy May I?" There is no risk to the second alternative if: estimates of the amount of time required for the company to become self sustaining aren't flawed, the plan is executed without error, the company's customers and markets don't change, the company does not require any midcourse changes in direction, the VC's don't impose any foolish strategies on the company, VC funding fads don't change, and the capital markets don't dry up... I have actually seen a VC try to sell the concept of staged funding to a founder. Here is the pitch: "It will keep your cost of capital down and you will be able to retain more of the company... and therefore more control. You'll get a higher valuation if you delay most of your funding until later." Yeah, Right. Somehow I don't think this VC was really that interested in reducing the founder's cost of capital or helping him retain control of the company. How many VC funded companies survive and blossom into winners. I don't have the statistics. I have heard 1 out of 9. Scott Woodard who sees a whole lot of the local angel deals has said 1 out of 4 or 5. Let's say its 1 out of 6. Now of the winners what portion of them became successful without tripping up and running into at least a few problems along the way. Not many of them. Say 1 out of 3?. Multiply these odds out. It's not good. When a VC does staged funding he is betting with these odds and the founder is betting against. Now if the founder screws up a bit, the company can still survive and prosper... it's just that he may not. As I said in my first email, Stanley Pratt the founder of Venture Economics did the research and found that the typical VC funded company ran through an average of 3.3 CEOs. Who do you think is the first casualty? These are not my numbers. They come from the Dean of VC performance statistics, Stanley Pratt. Oh by the way, if the founder's original law firm is not already within the VC's sphere of influence or can't be made loyal to them, they will find a way to replace it with a firm that will do their bidding. When the founder gets canned, and if they refuse to voluntarily fall on their own sword, the founder will be dethroned at the hand of his own palace guard. The bottom line is... When someone encourages you to accept funding in stages, look closely at where their personal financial interests lie... and where yours do. Cast a doubtful eye not just on the VCs, but their groupies as well. THE FIRST ROUND VALUATION DOESN'T COUNT Once you understand the above its becomes obvious why the first round valuation doesn't count... at least not where the investment is staged. There are typically multiple rounds of investment, at least for the companies that survive and prosper. Most of the VC money is invested not in the first round but in subsequent rounds. Each series (a, b, c, d, e, etc) of stock gets priority rights over the prior investors. This is smart investing. As a practical matter you really don't know what you are investing in until you have been with a company through a round. Why put all your money down until you really understand the company and the management team? Did you think the VCs that made those alleged 24 hour investment decisions during the heyday of dot.com gold rush were fools? The initial investment was just part of their due diligence. (By the way, if you're interested in Due Diligence, get Sahakian's Due Diligence Checklists, one of Amazon.com's top sellers on this subject) The valuation of the first round of investment isn't so important to the economic success of a VC. For companies that fail, the money is lost regardless of the valuation. For those that survive to go on to multiple rounds, most of the money is placed in the subsequent rounds. Bob Geras told me that he's done over 90 deals in his career and his experience is completely alien to mine. Unfortunately, I find it difficult to deny the simple verifiable mechanics of what I'm saying. I subscribe to a newsletter that tracks VC investments. It must report on over 100 VC investments a week. You don't have to be a statistician to see that There are multiple rounds and the big money gets invested in subsequent rounds. The money gets invested to subsidize negative cash flow (aka "a high burn rate"). Your readers shouldn't take my word for it. RedHerring.com has an emailed newsletter (called "dealflow") that does a decent job of tracking VC investments... and it's free. They can just go to the RedHerring site, sign up for the newsletter and watch is happening. They will see exactly what I am telling them they will. You know, there is normaly a grain of truth to most humor. I didn't make up the term "Vulture Capitalist" By the way I was just cleaning up some old reading and saw an article on page 51 of December's i-Street Magazine about how Z Edutainment suddenly woke up to what was going on just prior to their closing (with Angel investors). The article said they canceled the closing but were left "particularly vulnerable" because of spending in expectation of the closing and had to layoff some of their employees as a result. I believe these disputes occur more often than is commonly believed. And they don't seem to adversely affect the reputations of the VCs involved. How about Filipowski... in my book he is about as tough, smart and resilient an entrepreneur as you can find. If it can happen to him it can happen to anyone. In his first dance with a VC, he got fired from his own company. He got marched out, in front of his own employees, by security guards. Then someone made sure that there was a feature article about this personal humiliation two days later in the Sunday Business Section of the Chicago Sunday Tribune. Not a prime example of the gentlemanly behavior that VCs like to claim as their own. He did all right by himself and his VC's in his next company, Platinum Technologies. He was forced to start from scratch and literally had to start the company in his basement. I saw it. He even gave me the short tour. The VCs came in only later after the real risk was over. The VCs seem to be able to dish it out, but not so good at taking it. In the first major fight with a VC in which I was personally involved, I was surprised at how easy it was to get the VC's to spend their investor's money to buy their way out of the unpleasantness. The suit was threatened but not filed. It took about 3 months of negotiation to settle it. They made the settlement look like an investment decision. In another one, my client called me at 11pm outside his company saying he had just been fired... by the VCs acting in concert with the very CEO he hired. Despite having founded the company with his own $250,000, when the VCs came in they restructured the company so that most of his stock was basically non-vested (the agreement required him to sell his stock back to the company for a pittance if he got fired). The agreements were done by the VC department of a large well known California law firm. The company was not a loser. It was doing quite well... the VCs considered the investment one of their stars. There are more famous examples of this type of behavior by VCs in very public situations (Apple, Cisco, Compaq). It happens. Whenever it does, it doesn't seem to harm their business or their reputation. How many VC supplicants do you think have the temerity to ask a VC for three good references and three bad ones? FROM FOUNDER TO CONTRACT EMPLOYEE Sometimes you have no choice but to go the VC route. That's fine. My concern in the original email was of people being misled by VC propaganda. There are people who pour blood sweat and tears into a company, then seek out venture capital... and they don't realize what they are getting themselves into. If they understand the full implications of the documents they are signing, there is nothing wrong with that transaction. If they think that the VC is handing over his money to them... they may be surprised. What is often really happening is that they are investing their company into the venture capitalist. They become something more akin to the VC's contract employee. Even for a startup, there are substitutes for Venture Capital. There is Partner Money... and there is Customer Money. I did some research on software companies about 10 years ago. Most of the then most successful sofware companies were started with Customer Money from a major strategic customer. The best thing about Customer Money is that you don't have to pay it back like investor money. Also, Customer Money just makes investors desire you all the more. Bob Geras complains about founders using lawyers... after they have found themselves used and then thrown off to the side of the road. How about the abusive manner in which VCs use them? These investment agreements are some of are some of the most unreasonable and one sided agreements that exist in the business world. http://alliancetalk.com/vc.htm#7 Because they are all drafted to be as reaching as possible. They all come out of the same play book... and contain pretty much the same unreasonable provisions. At least in the last 10 years, they all seem to have a provision requiring that the management stick closely to a written budget controlled by the VC (though their representatives on the board and/or through their control of the board). These provisions prevent the CEO from reducing spending in one area, or increasing it in another. I remember one of these where it explicitly stated that the CEO had a margin of $1,000 before he had to go back to the Board/VC to get approval. What that means is that he can't run the company in any practical way without violating the agreement. The obvious intent was to make sure that the founder would exist in constant violation of the agreement. I was wondering how it is we could put what I'm saying here to a verifiable test. Ron, how about this. Why don't you see if you can get a handful of your readers (CEOs of failed startups who were funded by "Tier 1" VCs who aren't exactly certain about what happened but aren't happy with it) to volunteer themselves and their closing books. We will all get together and I will walk you and them through their closing books in real time and point out all the gotcha's and what went wrong. We'll maintain their confidentiliaty so they get no implied threats of being shunned by the VCs. By the time your done, we'll have you as well educated about this subject as you have become educated about IPOs. One person that I talked to suggested what is needed is some type of consumer's reports on the VCs. Ron are you up to the task? This Closing Book Review Session would educate you to ask all the right questions. Maybe you could even collaborate with someone to assemble a collection of founder's stories into a book. Curtis Sahakian PS: PPS: |
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