Venture Deals: Be Smarter Than Your Lawyer and Venture Capitalist is the definitive guide to venture financings. This book is for anyone who wants the insider’s guide to raising money, negotiating deals, and to know what really makes venture capitalists tick.
Fred Wilson has a spectacular post up on how VC funds should think about reserves. It’s even more valuable to entrepreneurs so they can understand how the best VCs think about reserves, giving the entrepreneurs ammunition to ask their investors how they are thinking about reserves.
I only noticed one thing missing from Fred’s post which is a statement about cashflow which I commented on.
“Fred – phenomenal. The only thing I noticed missing was a comment on fund cash flow. To recycle, you have to have the cash flow. If you don’t have the exits to generate funds to recycle, you can hit a cash flow wall where your reserve model breaks (since you don’t have the cash to fund the reserves.) There are several solutions to this, including recalling capital, having an annex fund, and suspending management fees, but the best is having the cash in the first place …”
In addition to the post being great, the comments have a lot of rich stuff in them as well.
Scott Belsky has a great post up titled Don’t Get Trampled: The Puzzle For “Unicorn” Employees. In it, he’s got a bunch of questions, along with detailed discussion, that you should ask your potential employer if you are considering a job at a unicorn (company with > $1b private valuation.) His suggestion is to strongly “audit your comp” in advance.
The questions include:
- Have you raised capital with liquidation preferences, and what are they?
- How many months of runway do you have?
- If you need to raise more money but are unable to do so at standard terms, will you accept less favorable terms or will you raise at a lower valuation?
- Has the company taken on debt?
- Does the company aspire to be a public company?
- If the company’s plan is to stay private for the foreseeable future, have there been secondary sales for employees and/or founders?
- Have the company’s financials been audited?
I encourage you to read the whole post at Don’t Get Trampled: The Puzzle For “Unicorn” Employees.
Today’s great post is from Bilal Zuberi @ Lux Capital. In it he asserts that Friends Don’t Let Friends Have a Lazy VC/CEO Relationship. I see this play out so many times in so many ways that – while it seems obvious – it’s an important reminder to all entrepreneurs who hear their friends complaining about their relationship with a VC.
Oh – and make sure your VC has a sense of humor. For example:
I love it when David Hornik – one of the very first (maybe the first) VC bloggers writes a post. Today’s is Want to get funded? Get an introduction! So simple, yet so often overlooked or ignored.
The punch line – it’s the transitive property that we learned about in elementary school math:
So how do you get funded? Step one — get an introduction. Find someone you know who can introduce you to the person you want to pitch. The closer your relationship with the person making the introduction, the better. And the closer that person’s relationship with the VC the better. I’ve written about this before and described it as “borrowed credibility.” If you are being introduced by someone who has credibility with the VC, and you have credibility with the person making the introduction, you will have credibility with the VC.
I learned about this in elementary school math class — it is called the transitive property:
A has credibility with B
B has credibility with C
A has credibility with C
And as a corollary to the traditional transitive property, (1) the stronger the credibility between A and B, and (2) the stronger the credibility between B and C, (3) the stronger the credibility between A and C.
If you don’t follow VentureBlog, you should. It’s the original.
Tom and Tony of tastytrade talk with Brad about Foundry Group, Techstars and Bootstrapping…
Reid Hoffman, founder / executive chairman of LinkedIn and partner at Greylock has started blogging. Well – he’s started writing long form essays on a blog that my understanding is will come out about once a month.
The first post is If, Why, and How Founders Should Hire a “Professional” CEO. It is outstanding and I expect Reid’s blog should be on your must read list. My only complaint is there are no comments open – I’d encourage Reid to engage with people reading this, rather than just lecture to us!
Q: When building a financial projection model for a pitch to VC’s, should you include future rounds of funding in the model or simply show what measurable goal you are trying to achieve with the current round you are seeking?
A (Brad): It depends on the stage of the company. But first, it’s important to understand how a VC is going to look at your projections in the first place.
- Early and pre-revenue: Investors are going to be most interested in your near term burn rate and how long their money is going to last. Focus on putting this information front and center – don’t hide it. Recognize that your revenue is totally speculative so the “base case” is going to be zero revenue.
- First product in the market, < $100k / month of revenue: Revenue matters here and the projections out into the second and third year will give a good indication of how you are thinking about the ramp of your business. However, if your revenue is modest, a smart investor is going to look at your gross margin also. If you are a recurring revenue business, the month-over-month growth – both of revenue and gross margin, is going to be important.
- Meaningful revenue, > $1m / quarter: You have entered the zone in which you have a real business and likely can have a credible growth plan out three or more years.
Now, in every case, a VC is going to be interested in how long the current round of financing is going to last. In early cases, they are going to focus on cash / monthly-burn-rate. In later cases, they will factor in some amount of revenue and gross margin projection, but likely discount both, viewing you as being overly optimistic on revenue as well as the gross margin percentage.
Then, building off of this, they will be interested in how much additional money you think you will need to get cash flow positive. They’ll calibrate this against whatever your current plan is. The earlier the life of your company, the more skeptical the VC will be of any projections of revenue, and any time horizon greater than one year.
Update: I just noticed a twitter comment that said “I would suggest that it should take you up to their expected exit as that is most definitely their primary concern.” While some investors may ask for this, it’s the exception as most rational investors will want to understand what it takes to be cash flow positive. It’s impossible to predict the exit as there are too many variables at play, including the notion that you can’t force an exit. However, you can run a business indefinitely without additional financing if you are cash flow positive. So I’d assert that showing the plan getting to cash flow positive is much more important than showing the plan getting to an exit.
Q: On page 105 of the second edition of Venture Deals under Debt Conversion Mechanics, you state: “Therefore, having outstanding debt (that doesn’t convert) can be a bad thing if an entrepreneur ever gets sideways with one of the debt holders”. I infer this to mean that convertible debt cannot bring about the same bad results. Is that correct? How can the company trip conversion so that debt holders cannot enforce these bad results?
A (Jason): Convertible debt only automatically converts (normally) under two circumstances: One, the company completes a financing of X amount or two, the debt holder elects to convert. We’ve never seen convertible debt where the company can unilaterally convert the debt, thus the caution around getting sideways with a debt holder.
Q: What is the best path to take if a VC which has invested in my company closes down, but we have not exited and are still operating profitably ? What happens to the LLC entity that was formed at the time of investment? Do we ask the VC for our shares back or buy them back at a discount?
A (Brad): First, you need to understand what actually happened to your VC firm. There are lots of specific points in time to consider. Let’s start with two magic milestones – year 5 and year 10.
1. The VC is outside their five year investment period. Most VC funds have a five year investment period. This is the time frame in which they can make investments in new companies (those that they haven’t already invested in.) However, most funds last 10+ years and can be extended for many more years. In this case, even if a fund is outside of its investment period, it can still make follow on investments in your company.
2. The VC is outside their ten year fund period. As mentioned above, most funds last for 10 years. However, they often have two, one-year automatic extensions, resulting in a 12 year life. Beyond 12 years, the fund can continue to be extended to operate with approval from the fund’s investors (the LPs). Many funds end up operating for 15 – 20 years.
Now, in each of these cases, you’ll have two situations – the VC firm has raised a new fund or it’s hasn’t. If it has, then the firm itself is still “in business” even if the fund that has invested in your company is getting older. If the firm has raised a new fund in either case, then you have nothing to worry about. However, if the firm hasn’t raised a new fund by year ten, it’s like to be considered a zombie firm.
Now, these zombie firms may still be operating, managing their existing investments, but not making new ones. As time passes, and a firm clearly is not going to raise another fund, most of the partners move on to other things. And this can go on for a long time as long as there is at least one partner from the VC firm still engaged in managing it.
Ultimately, we come back to your question. What if the firm actually shuts down, either because the LPs won’t continue to support additional extensions, or the remaining partner doesn’t feel like continuing to manage things. There are a few different options.
1. Distribution of shares to a liquidating trust: In this case, the equity in your company held by the VC fund now belongs to a completely passive entity that is simply going to exist until the shares become liquid, either through a sale or an IPO.
2. Distribution of the shares to the LPs: Similar to #1, but you now pick up a whole bunch of new shareholders in your company, who were there LPs of the VC fund. No one really likes this option – LPs don’t want private company shares, the companies don’t want all the new shareholders, and the VCs likely have no upside after the distribution.
3. Managed liquidity of each company: In this case, the VC will sell off each company in whatever manner he can at the point of time, either via a secondary sale to another investor, or a sale of the shares back to the company. By this point, VC funds typically have two kinds of companies in them – ones that are worth something and ones that are worth nothing. The graceful VC knows the difference and behaves appropriately. The non-graceful VC tried to squeeze blood out of rocks.
Regardless of the situation or outcome, there isn’t a simple, straightforward one. This is compounded by the complexity of VC / LP relationships, private company dynamics, and the optimism of many investors that “something good will come in the future”, more formally known as “maintaining option value.”