Author Archive

What Are the Pros and Cons of Investment From a Strategic Entity?

Q:  Can you please touch on issues associated with first round financings from corporate or strategic investors. Particularly when the strategic is a competitor. What are some of the pitfalls and opportunities associated with this type of an investor in an early stage company?

A: (Jason)  There are both potential positives and negatives taking money from a strategic investor.  And despite the arguments for and against, there is also are no bright line rules on wether or not you should accept strategic money.

Let us first look to the positives.  Usually the biggest perk is the ability for a strategic investor to be able to accelerate and help your business in ways that a venture capitalist can’t.  Strategics can offer access to manufacturing capabilities, technical resources, sales channels, foreign joint ventures, guaranteed retail shelve space, etc.  The strategic can leverage their business to help you.

Also many strategic investors don’t consider themselves "financial investors" in the same way that venture capitalists do.  So while a VC might need to realize a return in 5-8 years and be happy with a certain return, many strategics are deriving other benefits besides the ultimate return.  Therefore, they may be a little easier on you if things don’t go quite as planned, so long as they are still deriving utility from the other benefits. 

This also can lead to a problem, though.  If you investor isn’t ultimately financially motivated to see your company succeed, that can be a conflict between them, you (assuming that you are financially motivated) and any venture investors (who I guarantee are financially motivated).  You may find yourself trying to make decisions that will promote one set of interests over the other.

We’ve seen this many times.  The questions is "how do I know of my strategic investor is motivated by venture-type returns versus ‘something else?’"  Here are some clues:

  • If your strategic investor is asking for terms that a venture capitalist would not, such as:
    • A right to buy the company / first look / call agreement (which you should never agree to, as this will kill any other potential suitor from speaking to you);
    • Warrants / other equity kicker for free or based on services provided to the company;
    • Restrictions on who you can sell your product to; or
    • As a condition to financing, entering into some sort of business arrangement.
  • If you ask them if they are financially motivated and they say no.  (Don’t laugh, many will be completely open about this.

To be clear, even if your strategic is not financially motivated, it still might make a ton of sense to take money from them, you just need to weigh the benefits of the "stuff" they bring to the relationship besides money.  For instance, a performance-based warrant for true performance may be appropriate. 

One thing to consider is a board / observer seat.  Most strategics don’t want a board seat as they don’t want the fiduciary duty issues present with their own business and yours.  This is especially true if your strategic is a competitor.  But they many times will ask for an observer seat and you need to carefully consider what type of information will be in their hands at the end of the day. 

A note on competitors investing in your company.  I haven’t seen many of these arrangements end well.  Usually, the distrust of sending information back and forth quickly chills the relationship.  Do you really want your competitor getting your financials and board presentations?  Do you want them to know if you are negotiating a deal with one of their other competitors?

In general, we’ve had both good and bad experiences with strategic investors.  We’ve had deals that without them, we wouldn’t have had nearly the success that we did.  We’ve had deals where we never saw or heard from them again after the funding.  We’ve had other cases where the noise in the machine caused by their wake was quite disturbing.  In this particular case, it appeared that the strategic’s sole intention was the bankrupt the company and take their technology. 

It’s really an individual choice.  I’d recommend getting references from prior investments that they’ve made to see how helpful they really can be. 

How Can I Invest In A Venture Capital Firm?

Q: Your site talks a lot about VCs investing into companies but I can’t find any information online (even on the VCs websites) about how VCs solicit investors to their funds.

I want to invest with a VC but I don’t know what is the minimum VCs accept. Who in the firm should I contact to invest? What kind of terms should I expect? What kind of returns does an investor normally expect? How soon would I get my money back with the profit? Would I be in a position to make demands and say "I want a fourth of my investments to go to XYZ company that is looking for VC funding"? etc.

A:  (Jason) Most venture firms do not take individuals as investors unless they have a pre-existing relationship with them.  Most VC investors are institutions, endowments, pension funds and other corporate entities that professionally and regularly invest in VC funds  As an individual, your best way of investing is either through high net worth family office organizations or through your financial broker, if they participate in these types of offerings.  Because of this, and because of securities laws that I won’t bore you with, you’ll never find information on VC websites on how to invest. 

As for your ability to control terms or designate investment particulars, this probably won’t happen.  The large institutions that invest in funds drive terms, not individuals, so if you do decide to invest, you’ll piggyback off the terms the VC fund and it’s largest investors negotiate. 

Am I In Trouble If I Don’t Raise Money From Kleiner?

Q: It seems that the venture community is dominated by a very few large names (Kleiner, Sequoia, etc.).  If I don’t get funded from one of those firms, is my company toast?

A: (Jason)  Nope!  While Kleiner and Sequoia deserve their great reputations, the list of successful venture backed companies that had syndicates that didn’t include either Kleiner or Sequoia is extremely long.   While having a great VC firm as an investor is often very helpful, the idea that you are “toast” if you don’t have an investment from one of them in nonsense. 

The real key is finding a partner at one of these firms who understands your business and whom you think you’ll have a great working relationship with.

Should I Pay My Venture Capitalist To Consult For My Company?

Q:  My company is backed by VC firm to whom we also pay a $2k/month "consulting fee." We have raised approximately $2MM from them in a Series A. Is that type of consulting payment typical in an early stage venture?

A:  (Jason)  I want to vomit again.  We received this question just a  few short days after posting that entrepreneurs should NOT pay their lawyers for introductions to VCs and how scummy of a practice that was.

Now today, we get this question.  This is even worse.  The answer is NO.  Companies should never pay their VCs consulting fees, board attendance fees, or any type of fees related to their involvement in their company.  I’ve never worked with a reputable VC firm that charges their companies to help them succeed.

As a venture capitalist, we are paid a management fee by our investors that is our "salary" and we receive a percentage of the profits (called "carry") on our fund.  We don’t get paid to sit on boards and certainly it is not appropriate for them to "round trip" your investment capital by paying themselves part of it. I would wager to guess if their investors knew they were doing this that the investors would revolt.

I’m sorry to report, but not only is this not typical, it’s unheard of in the venture world when dealing with reputable folks.

(Note, private equity is a totally different matter and fees are commonplace, but it’s a totally different model)

Should I Pay My Lawyer A Success Fee For Venture Capital Intros?

Q: My lawyer is asking for a "success fee" for a referral to a potential investor in my business. Since he’ll be doing the legal work, he’s offered to charge only 3% on the amount funded (solely from this one contact) as opposed to a 5% that a typical investment banker would charge (even though he’s not an investment banker himself).

As this is the first venture I’m actually raising capital for, I am simply unfamiliar with this practice in the legal world. Is this a common industry-wide practice? Should I be wary of this offer? Although I don’t feel like he is trying to take advantage of me in any way, it does feel a bit like he’s trying to double-dip.

A: (Jason)  Without sounding too unprofessional, I want to vomit.  This is egregious behavior by your lawyer and you should not accept paying ANYTHING to him for introducing you to potential investors.

First of all, it’s part of a lawyer’s job to introduce you to any investor contacts he may have.  If you get funded, he gets paid and gets to bill you throughout the lifetime of your company.  If you don’t think he is already making enough money, see my post on start-up lawyer compensation from my personal blog. 

Second, while investment banks may offer you a deal at 5% (and in my experience this can be negotiated down), individuals who find money for you (normally called "Finders") normally charge in the 1-2% range, so his quote is at least 50% too high.

Lastly, venture capitalists prefer to invest in deals without finders.  We don’t like funding a company that has to pay someone part of the deal proceeds.  We want our money to be used to operate and grow the company.  You will see many VC term sheets that have provisions that specifically call out the absence of finders fees. 

So yes, your lawyer is double dipping.  And that is stating it very nicely. 

How Did We Get Our Idea For Our Startup?

Q:  We just started looking for venture funding and I have a question. Why do VC’s ask us how our idea came about? Are they looking for an emotional and inspiring story or are they worried that we may have taken our idea from someone else or, what I believe is the case, do they want to see if we were driven by an opening in the market that we observed? Of course, if we are giving our answer in a way that addresses one or two of these issues then you are probably missing the third.  Please help!

A: (Jason)  Without sounding too glib the answer is "all of the above and maybe more, probably."  Your guesses as to why are probably accurate and it, of course depends on to whom you are speaking with.  I’ll address each of your guesses individually.

1.  "Emotionally and Inspiring Story" -  Without getting all Sally Struthers-like, it is nice to see engaged and passionate entrepreneurs.  Building a successful startup is really, really tough.  If you aren’t in love with the company going in, it will not turn out well for you or your investors.  That being said, don’t put on an act.

2. "Taken Our Idea from someone else" – This is a big one.  If you come and pitch a next-generation social networking site and previously worked at Facebook, we are going to have an in-depth discussion.  Maybe you didn’t steal it, but maybe your former employer will have a claim on the intellectual property developed while you were employed. 

3. "Driven by a new market" – This also might be part of the question.  Whatever VC you speak to, you should know more about your market than they do.  I, personally, ask many questions and rely on them as part of my education.  Maybe you really have found an "unscratched itch."

One other potential reason is to see how you sell the vision and product.  You are going to get this question often from potential customers and this is a way to see you sell and see how efficiently you can answer a potentially complicated question. 

Or, perhaps it is just a trite icebreaker and the VCs are just asking you this so they’ll have time to answer emails on their blackberry while you wax poetically. 

Founders Termination Clause In Term Sheets?

Q: Thank you very much for your term sheet series.  Not being that familiar with "specific" term sheets, I have heard something about VC terms that effectively allow the VC to fire the founder(s) and in the process relieve them of their shares since they had then left the company before liquidity. I have read a previous Ask the VC post about the ‘moral’ and ‘reputation’ reasons that VC’s will not do this.

However I am more interested in the legal binds and would like to know if these sort of terms are something that is standard/negotiable in various term sheets.

A: (Jason).  There is certainly nothing in a standard term sheet that specifically addresses this.  I’ve seen founder / CEO termination clauses in term sheets that effectively say "if X, Y and Z doesn’t happen, you are fired."  I’ve always found these to be egregious and worse yet, sets up the VC and founder / CEO to be enemies, not collaborators trying to help the company be successful. 

As for different mechanics that a VC might use to remove a founder / CEO / founders, etc.:

1.  Board control – if the VC has board control, or the ability to elect a majority of the board, terminating founders and / or executives is fairly simple;

2.  Voting rights – be careful that there aren’t any non-standard control provisions in the voting rights that allow the VCs to vote people "off the island."

As far as acquiring the terminated party’s shares, I’ve never seen a VC with a contractual right to be able to do this.  I’ve seen some documents which gives the shares back to the company, but never the VC.

And shares going back to the company is rare as well, so long as we are talking shares that have vested under a option plan or are not subject to some sort of repurchase.  Those shares should be free and clear the property of the terminated party.

What Kind of Benefits Can I Expect Working at a Startup?

Q:  What kind of benefits do start-ups typically offer? I don’t mean salary or equity: about which you already posted a lot of information. I am talking about health and life insurance, disability insurance – all of the typical benefits one receives when working for a large and established business.

Do you recommend a particular benefits package configuration to your companies? Are benefits ever a part of your conversations with your companies about the ‘costs’ of running the business?

How do you see startups dealing with a regulatory landscape designed for an entirely different type of organizations?

A: (Jason)  In order to best answer your question, I asked Dan Cutler from TriNet to opine.  Dan and TriNet have been great partners to our portfolio companies – so much in fact that we decided to switch our own benefit offerings over to TriNet.  Here are some of Dan’s thoughts, below of which I agree with completely.

A typical VC backed company will offer to pay 100% of a good benefits package for the employee and between 0-50% for dependent coverage.  A good package will include medical options PPO and HMO and dental, long-term disability and a minimum of 10K life insurance with an option to buy more.

In order to hire and retain "A" players the savvy entrepreneur will use a PEO (Jason note:  "professional employee organization" like TriNet) that can offer self-help HR, online enrollment, several benefit plans to choose from,  a PeopleSoft HRIS,  tiered pricing,  and will pay a flat rate administrative fee.

Regarding compliance issues.  All energy spent by the business owner to keep compliant is a waste of time when you can outsource HR and allow your outsource provider to shoulder the risk.  The business owner’s job is to move the business forward and select good partners that will provide assistance in areas that are not core.

Should I Be A Shareholder Representative?

Note:  This was actually a question that I received from a colleague via email, but thought I’d post it here given the content. 

Q:  My company is close to signing a contract to sell the businessAlthough I’m prepared to do the role, one of the board members has suggested that we consider using a third party shareholder representation firm instead.  Jason – I see that you’re involved with Shareholder Representative Services, the firm my board member suggested.  I’m pretty committed to my company so what are the advantages and disadvantages of going with a third party rather than just doing it myself? BTW, I’m currently the CFO and plan on staying on for at least a while post closing.

A:  (Jason)  My short answer is that under most circumstances you want to avoid this job if at all possible.  The shareholder rep issue is a problem that we and many other VCs have been struggling with for years on our M&A deals.  Most buyers require that the stockholders appoint someone to have power to speak for all of the stockholders following closing to ease the administrative process.  On most of our prior deals, somebody (usually one of the VCs) had to be the rep, and usually nobody wanted to do it.  To be blunt, the job sucks.  It takes a lot of time and is a big distraction if the person does the job properly, and not doing it properly can subject the person to risk of being sued under some legal theory like negligence, breach of fiduciary duties, unequal treatment, conflicts of interest or something similar.

In your particular situation, you have the added complexity of inherent conflicts of interest. If you are going to work for the buyer following closing, which is effectively what will happen if you continue to work for the company, you’ll have the problem of having to argue on your former stockholders’ behalf against your new employer if any claims come up. That significantly adds to the legal, ethical and emotional challenges you’ll be facing if you serve as the representative, especially if you personally have financial interests on one or both sides.

For all these reasons, I got involved with Shareholder Representative Services.  I serve on their advisory board, but more importantly, our funds have used them on a few of our recent exits and have been very pleased.  The selling company hires SRS to serve as the shareholder rep, and they professionally manage the entire process.  We’ve found that we get better information and quicker responses from them than if one of the other investors serves as the rep, we get to avoid the risk and burdens of being the rep, and we still maintain significant involvement in the decision making process when material issues do arise. 

Because of SRS, we’ve determined as a fund that it is highly unlikely that we’ll ever serve as the rep again – it would have to be a deal with unusual circumstances that I can’t think of right now.  It’s not a good use of our time and is not in the best interests of our fund or our LPs.  Besides, we hire professionals to manage every other aspect of the M&A deal process.  Why wouldn’t we do the same with respect to the post-closing period?

VC Perspective on Intellectual Property

So today’s "great post" comes from er… me.  :)  Okay, so my partner Ryan and I did a podcast last week with Larry Nelson of W3W3 and our conversation covered both the intellectual property and patent issues we’ve faced as investors in high-technology companies. We definitely have a love/hate (ok, mostly hate) relationship with patents, so if you are interested in hearing (or reading) more, check it out here. Note the excellent intro and outro music, or the "bumper music" as Larry refers to it — it is from Soul Patch’s latest album and is therefore straight from Jason’s and my personal intellectual property collection