Later-stage rounds and “setting the bar too high”

I recently had a number of conversations with CEOs of later-stage startups (generating significant revenue) that went something like this. They want to raise more money, and VCs are offering them money at a high valuation. The CEO is worried that taking money at that valuation will “set the bar too high” and make it difficult to sell the company – if the time comes when he/she thinks it makes sense to sell – at a price that isn’t a significant multiple of that valuation.

These CEOs are worrying too much. VCs know what they are doing and almost always invest with a financial instrument – preferred shares – that protects them even when the valuation is very high. Preferred shares behave like a stock on the upside and a bond on the downside.  The only way investors actually lose money is if the company is sold for less than the amount of money raised (which is generally significantly lower than the valuation).

Here is what the payout function looks like for common stock (for example, what you get when you buy stocks in public markets):

And here is what the payout function looks like for preferred shares:

 

So, to take a concrete example, Dropbox reportedly raised their last financing at a $4B valuation*. If you think of this as a public market valuation of common stock, you might think this means the VCs are betting $4B is the “fair value” of the company, and will lose money if Dropbox’s exit price ends up being less than $4B.  But in reality, assuming the standard preferred structure, the last round investors’ payout is as follows :

Scenario 1: Dropbox exits for greater than $4B ==> investors get a positive return (specifically, exit price divided by $4B)

Scenario 2: Dropbox exits for between $257M (total money raised) and $4B ==> investors get their money back (possibly more if there is a preferred dividend)

Scenario 3: Dropbox exits for less than $257M ==> investors lose money

If reports are true that Dropbox is profitable and generating >$100M in revenue, then scenario 3 – the money losing scenario – is extremely unlikely.

Will investors be thrilled with scenario 2?  No, but they are pros who understand the risks they are taking.

Going back to the entrepreneur’s perspective, in what sense is a high valuation “setting the bar high”?  In the preferred share payout model, there are two “bars”:  money raised and valuation.  I don’t see any reason why entrepreneurs shouldn’t be as aggressive as possible on valuation, especially if they are confident they won’t end up in scenario 3.

An important point to keep in mind is that, in order to maintain flexibility, entrepreneurs shouldn’t give new investors the ability to block an exit or new financings. Investors can get this block in one of two ways – explicit blocking rights (under the “control provisions” section of a VC term sheet) or by controlling the board of directors. These are negotiable terms and startups with momentum should be very careful about giving them away.

 

* Note that I have no connection to Dropbox so am just assuming standard deal structure and basing numbers on public reports. I am making various simplifying assumptions such as not distinguishing between pre-money and post-money valuation.

 

A few points about the “tech bubble” debate

Pretty much every day now a major blog or newspaper writes an article asking whether we are experiencing another tech bubble (e.g. see today’s NYTimes). I don’t know whether successful private companies like Groupon, Zynga, Facebook and Twitter are over or under priced since I don’t have access to their financials. Regarding public tech companies, it seems to me that incredibly innovative companies like Apple and Google trading at 19 and 22 P/Es respectively is pretty reasonable.

Rather than take a side on the bubble debate, I mainly just wanted to make a few points that I think should be kept in mind in this discussion.

1) A bubble is a decoupling of asset prices (valuations) from their underlying economic fundamentals (which is why the graph at the top of the NYTimes article today is meaningless). During the housing bubble of 2001-2007, smart economists noted that housing prices were significantly higher than their fundamental value (in housing, a common way to measure this is price-to-rent ratio, which is analogous to price-to-earnings in the stock market). During bubbles, investors stop valuing companies based on fundamentals and instead invest based on the expectation that prices will continue to rise and “greater fools” will buy the assets from them at a higher price. This process is unsustainable, which is why bubbles eventually pop.  But when the economic fundamentals are strong, the last buyer can always hold onto the asset and collect a return through the asset’s cash flows, thereby preventing a pop.

2) The forces that drive the internet economy are strong and will probably only get stronger. I argue this regarding online advertising here so won’t repeat it. Since I wrote that post we’ve also seen a number of tech companies emerge that are generating significant revenues through non-advertising means – “freemium” (e.g Dropbox), paid mobile apps, virtual goods (e.g. Zynga), transaction fees (AirBnB), etc.

3) I think it’s a good thing that the speculation on large private tech companies is happening in secondary markets where the risks are being taken by institutions or wealthy individuals. This is in stark contrast to the dot-com bubble of the 90s where many of the people holding the bag when bubble popped were non-rich people who bought stocks through public markets. Obviously this could change if we have a bunch of tech IPOs.

It’s not that seed investors are smarter – it’s that entrepreneurs are

Paul Kedrosky recently speculated that there might be seed fund “crash” looming. Liz Gannes followed up by suggesting seed investors are a fad akin to reality-TV celebrities:

In many ways, what [prominent seed funds] are saying is that they’re just smarter, and as such will outlast all the copycat and wannabe seed funders as well as the stale VCs with a fresh coat of paint. But then — Kim Kardashian is the only one who can make a living tweeting. At some point it will be quite obvious whether the super angels’ investments and strategy succeed or fail.

Here’s the key point these analyses overlook: It’s not the seed investors who are smarter – it’s the entrepreneurs. Consider the case of the last company I co-founded, SiteAdvisor. We raised our first round of $2.6M at a $2.5M pre-money valuation. After the first round of funding, investors owned 56% of the company. Moreover, the $2.6M came in 3 tranches: $500K, another $500K, and then $1.6K.  To get the 2nd and 3rd tranches we had to hit predefined milestones and re-pitch the VC partnerships. Had we instead raised the first $1M from seed funds, we would have been free to raise the remaining money at a higher valuation. In fact, after we spent less than $1M building the product, we raised more money at a $16M pre-money valuation. We never even touched the $1.6M third tranche even though it caused us to take significant dilution. This was a very common occurrence before the rise of seed funds, due to VCs pressuring entrepreneurs to raise more money than they needed so the VCs could “put more money to work.” When SiteAdvisor was eventually acquired, we had spent less than a third of the money we raised. Compare the dilution we actually took to what we could have taken had we raised seed before VC:

Professional seed funds barely existed back then, especially on the East Coast. And even if they did, I’m not sure I would have been savvy enough to opt for them over VCs. I thought the brands of the big VCs would help me and didn’t really understand the dynamics of fund raising.* Today, entrepreneurs are much savvier, thanks to the proliferation of good advice on blogs, via mentorship programs, and a generally more active and connected entrepreneur community. For example, Founder Collective recently backed two Y-Combinator startups who decided to raise money exclusively from seed investors despite having top-tier VCs throwing money at them at higher valuations. These were “hot” companies who had plenty of options but realized they’d take less start-to-exit dilution by raising money from helpful seed investors first and VCs later.

Will there be there a seed fund crash? Seed fund returns are highly correlated with VC returns which are highly correlated with public markets and the overall economy. I have no idea what the state of the overall economy will be over the next few years. Perhaps it will crash and take VCs and seed funds down with it. But I do have strong evidence that prominent seed funds will outperform top-tier VC funds, because I know the details of their investments, and that their portfolios contain the same companies as top-tier VCs except the they invested in earlier rounds at significantly lower valuations.  So unless these prominent seed funds were incredibly unlucky picking companies (and since they are extremely diversified I highly doubt that), their returns will significantly beat top-tier VC returns.

* Note that we have nothing but gratitude toward the SiteAdvisor VCs – Rob Stavis at Bessemer and Hemant Taneja at General Catalyst. They offered what was considered a market deal at the time and supported us when (almost) no one else would.

The most important question to ask before taking seed money

There is a certain well respected venture capital firm (VC) that has a program for fledgling entrepreneurs.   The teams that are selected get a desk, a small stipend, and advice for a few months from experienced VCs.  I could imagine back when I was starting my first company thinking this was a great opportunity – especially the advice part.

Here’s the problem.  A few years into the program, approximately 25 teams have gone through it.  The sponsoring VC funded one team and passed on the other 24.  None of those other 24 have gotten financing from anyone else.  Why?  Because once you go through the program and don’t get funded by the sponsoring VC, you are perceived by the rest of the investor community as damaged goods.

Most early stage investors are bombarded with new deals.  There is no way they could meet with all of them, or even spend time seriously reading their investor materials.  In order to filter through it all, they rely heavily on signals.  The person referring you to them is a very big signal.  Your team’s bios is a very big signal. And if you were in the seed program of a VC who has a multi-hundred million dollar fund and who decided to pass, that is a huge signal.

Meanwhile, the unsuspecting entrepreneurs think: “I was at a prestigious VC this summer – this will look great on our bios and company deck.”  The truth is exactly the opposite:  the better the VC, the stronger the negative signal when they pass.

Thus, the most important question to ask before taking seed money is: How many companies that the sponsor passed on went on to raise money from other sources?

The best programs don’t have sponsors who are even capable of further funding the company.  Y Combinator simply doesn’t do follow ons, so there is no way they can positively or negatively signal by their follow on actions. (Although now that they have taken money from Sequoia people are worried that Sequoia passing could be seen as a negative signal.  I just invested in a Y Combinator company and was reassured to see Sequoia co-investing).  Other seed programs lie somewhere in between — they aren’t officially run by big VCs but they do have big VCs associated with them so there is some signaling effect.   (I would call this the “hidden sponsor” problem.  I didn’t realize the extent of it until I got emails responding to my earlier seed program posts from entrepreneurs who had been burned by it).

The most dangerous programs are the ones run by large VCs.  I would love for someone to prove me wrong, but from my (admittedly anecdotal) knowledge, no companies that have been in large VC seed programs where the VC then stopped supporting the company went on to raise more money from other sources.

As has been widely noted, startups – especially internet-related ones – require far less capital today than they did a decade ago.  The VC industry has responded by keeping their funds huge but trying to get options on startups via seed programs.  Ultimately the VC industry will be forced to adapt by shrinking their funds, so they can invest in seed deals with the intention of actually making money on those investments, instead of just looking for options on companies in which they can invest “real money.”  In the meantime, however, a lot of young entrepreneurs are getting an unpleasant introduction to the rough-and-tumble world of venture capital.

Disclosure:  I am biased because as an early stage investor I sometimes compete with these programs.

The Twitter investment and the decline of venture capital

There has been a lot of talk the past few days about Twitter raising $100M at a $1B valuation.  To understand what is going on from the investor side, you need to know about David Swensen, the man who (inadvertently) destroyed venture capital.

Mr. Swensen manages Yale University’s endowment and is the inventor of the so-called “Yale Model.”  Basically this is a model for people who manage the largest pools of capital in the world – universities, pension funds, wealthy family funds, etc.  The major idea behind the Yale Model is to put significant portions of one’s fund into “alternative asset classes” like venture capital.   Yale had phenomenal returns for many years (until this year, which was a disaster) and thus was copied by fund managers around the world.  This created demand to invest hundreds of billions of dollars into VC funds.  This in turn radically increased competition amongst VCs, thereby driving down their returns (public pension funds like California’s release the returns of their VC investments and they aren’t pretty).

What this means is that there are lots of VCs out there with huge funds and very little chance of getting “carry” (performance fees), since most will have negative returns (and they know it).  So instead they are collecting management fees (typically, 2% of the fund for 10 years, so 20% of the total fund).  They need to justify collecting these fees, which is why if you hang out with VCs you’ll often hear them talk about needing to “put more money to work.”  I would bet that the new investors were the ones arguing for Twitter to raise more and more money, even if it meant a higher valuation.  I’ve seen it happen many times.