Valuation Storm Brewing

"Something wicked this way comes…"
  — Ray Bradbury

We have just survived our annual audit season and it is clear to me that things are going to get increasingly murky, confusing and ugly for valuations in the venture capital world. For those of you not well versed in the intimacies of the portfolio company valuation methodologies, I’ll give you a quick overview.

As the SEC and accounting worlds continue to dig deeper into our post-SOX world, they are trying to find more appropriate ways to mark investments to market. Traditionally, VC’s have kept their investments at cost until a third party transaction (financing, sale, etc) has indicated a change in value. Conservatively, VC’s have marked investments down (say 50% of cost or $1) if they believed the investment was impaired. So, we pro-actively took write-downs and only took write-ups when a clear market transaction occurred (no guessing if something felt like it was worth more).  First the accountants targeted the publicly traded companies with their efforts in the hopes of avoiding the next Enron debacle from hidden factors. Then they started to look at privately held businesses owned by buyout shops. These firms usually have cash flows, predictability and clear public market comps. Now, they are turning their guns on the venture market and it is not going to be pretty.

In September, 2006, FASB published SFAS 157 (Statement of Financial Accounting Standards) with the goal of establishing a framework for measuring fair value. PWC drafted a nice 4 page summary (Please Welcome SFAS 157…). It defines fair value as:

"the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date."

Okay. How do you expect this to work for the venture world? They give more guidance…use one of three helpful approaches: market, income or cost. So let’s see how these work.

Market Approach: observable prices and information generated by market transactions. Huh?? So, three video sharing sites are launched. One gets a $75m pre-$ valuation because of some traction, brand name VC’s and such. Another gets a $20m valuation because it doesn’t seem to have the buzz of number one and a third one struggles to get a $2m valuation. You tell me which is the right comp. As I wrote in my post, The Black Art of Deal Pricing, valuation techniques for VC is art and has even alluded the academics who can’t get CAPM to work.

Income Approach: thank goodness. This one works well for PE deals. Figure out the profit/EBITDA, etc, determine market comps and voila, you have your answer. Wait, what do mean these companies don’t have earnings? What, you say many don’t even have revenue? And, the comps range from 10x EBITDA to 100+x EBITDA? What about DCF…can’t predict cash flow? Okay, let’s use Black-Scholes pricing…too volatile and no clear market comps?

Cost Approach: this one has to work. All you have to do is figure out replacement cost. Isn’t that just a couple of servers, some labor and a website? How could the VC’s possibly pay $25m pre-$ on this one when replacement was only about $1 million? Okay, these weren’t too helpful…maybe there is another way.

On top of the fact that none of the traditional valuation approaches work well here, you have the quantum issue with early stage companies. They are many different states concurrently at the same time depending on who is doing the looking and how much Coolaid is in the glass. Let’s say you have a company burning $300k/mo and has $600k left in the bank. What is that company worth? Well, if it can raise capital in time, it can close x, y & z deals, get to breakeven and you’re off to the races. However, if it can’t raise the capital, then you are selling servers and office furniture. This creates a rather boolean and Draconian gap in just the next two months. If you feel good about how things are going with the raise, then you are more likely to price closer to the likely term sheet valuation. If you aren’t, then you take it to a $1. Have any of you entrepreneurs ever been able to guess where your term sheet was eventually going to come in? Could be anywhere from $30-60m depending on how the senior partners are feeling that day at the partners’ meeting.

So, we get to sit down with our auditors and go through this drill for everyone of our companies. We have always said that we have no idea how the market will received certain developments or milestones. Is the sector hot (couple of big exits) and VC’s are climbing all over each other or is it stone cold? Does management wow investors or leave them unimpressed despite a solid underlying business? Has the market inflected or is it just a head fake? Does the technology scale or can we only make a couple million dollars worth?

Better yet, if the reporting date is December 31st, but your audit is April 10th, the auditors now want you to apply all information you know as of April towards figuring out December 31’s value. So, your company receives an acquisition offer in January or February. Clearly, the firm had much of that value in December as well. So, use the Feb acquisition price in December even though the deal might still fall through.

Please let the venture world go back to the old ways. They are more conservative. We subjectively mark down our assets and will only mark them up when we get a third party transaction. Don’t make us do mark-ups based on imperfect comps or implied future transactions. I remember my physics teacher saying: you can’t multiply an imprecise number with another imprecise number and get anything but a really imprecise result. And please do not make us do $10,000 appraisals on each of our companies each year ($200-300k cost per fund) just to check your SFAS 157 box…

Buzz in the Rail: Comscore Files

My friends at Comscore have filed to go public. A recent Mashable article has a few details on it as does their online SEC filing. It has been a long road for Gian and team, but they are another stellar example of persevering through adverse times to get to the payout. Tom Berman at Adams Street and Fred Wilson (then Flatiron, now Union Ventures) are both on the board and have been strong supporters of the company for years. It should also be noted that this is one of Divine Interventures (now defunct) few successful exits and goes to show that a good management team can overcome even that kind of burden… The deal will price in the near future.

How to Divide the Pie

Sam Martin sent in an email asking about determining founder equity. "What amount/percentage of equity is usually reserved for the founder, CEO, and management team.  Is there a rule of thumb for how you determine who should receive equity and who shouldn’t?  What is a common vesting schedule–if there is such a thing?"

Great questions and ones that we have to address with every deal. I have a couple of thoughts on the above:
1) Alignment of interests is critical…all the way down to the entry level Java programmer. Equity is the great connector. I am a fan of making certain that all employees have equity, even if only token shares. This means making certain that you have an option program in place and all employees are participants.

2) Setting equity levels is more art than science though there are ranges. At the start-up level, equity allocations will be larger since they will be diluted down with financings. As you start to near break-even, some ranges…CEO 5-10%, VP-Sales or Marketing 1-2%, CFO 1%, next level down .25-.5%.

3) Most of our companies have fairly consistent option plans that a lawyer who is familiar with VC deals can help set up. These usually have a one year cliff vest (e.g. no equity before 12 months) and then monthly vesting for the next 3 years…a four year vesting in total. Strike price is usually a fraction of the preferred and with the new 409A accounting rules, you’ll need an appraiser to CYA. The employee has two months to exercise options upon leaving. The company has the right to buy back those shares at fair market value.

4) Dividing the pie up should be split into two parts. The first is to divide the equity amongst the founding team. This is a matter of determining who deserves what and who has what leverage. Some founders go with an equal split mentality (four founders, each with 20% and another 20% set aside for future hires). Others go with a layered approach and different ownership levels. The second is to determine how much capital is coming in and what pre-$ valuation. If $1m is coming in at a $2m valuation, then the new money gets 33% of the business and all existing shareholders are all diluted down by 33% (e.g. the 20% above is now 13.6%).

The trick to all of this is to break these allocations into multiple steps, lock %’s down and then go to the next step. It is also key to have good counsel to make certain the appropriate provisions are in place such as a drag-along provision (if the majority agree to sell, everyone else has to also…avoids small, disgruntled investors from holding the company hostage) and a legal structure.

In short, though, share the wealth as it is a lot easier to row the boat together when incentives are aligned.

Mathematics of Success

I am back from Spring Break with family and in-laws. I had a relaxing week in South Carolina with good food, quality time with family and golf. The only downside in visiting my in-laws is the every present no see ’ems which always do a job on my skin. Being the soft-hearted VC that I am, they go wild for my blood I guess. Cortisone and Benadryl should get things back to normal by week’s end. So, slowly getting back into the blogging with a fine Mathematical analysis of success I received from our CFO, Judy Dorr. It definitively lays out what it takes to succeed:

"Mathematics 
  
From a strictly mathematical viewpoint it goes like this: 
What Makes 100%? What does it mean to give MORE than 100%? Ever wonder about those people who say they are giving more than 100%? We have all been to those meetings where someone wants you to give over 100%. How about achieving 103%? What makes up 100% in life? 

Here’s a little mathematical formula that might help you answer these questions: 



If: 
A B C D E F G H I J K L M N O P Q R S T U V W X Y Z 

is represented as: 
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26.



Then:

H-A-R-D-W-O-R-K 
8+1+18+4+23+15+18+11 = 98%



and 

K-N-O-W-L-E-D-G-E
 11+14+15+23+12+5+4+7+5 = 96% 



but, 

A-T-T-I-T-U-D-E
 1+20+20+9+20+21+4+5 = 100%



and B-U-L-L-S-H-I-T 
2+21+12+12+19+8+9+20 = 103% 

BUT, look how far ass kissing will take you.


A-S-S-K-I-S-S-I-N-G
 1+19+19+11+9+19+19+9+14+7 = 118%



So, one can conclude with mathematical certainty that, while Hard work and Knowledge will get you close, and Attitude will get you there, it’s the Bullshit and Ass kissing that will put you over the top."

The Power in Serving Others

“Act so as to elicit the best in others and thereby in thyself.”
              — Felix Adler

If you are into postings about inspiration, self-improvement or resiliency, Brian Kim does a good job with his posts at BrianKim.Net. It is one of the blogs that I track in this category and he has written a variety of interesting pieces such as the one on How to Find What You Love to Do.

As you may have noticed in some of my posts, I am a Karma fan. Good deeds and helping others creates a virtuous cycle. One of his more recent posts, The Power in Serving Others, has a simple message. It is not just the act, but the intent that counts. Random, selfless acts of kindness oil the wheels.

"You can call this whatever you want – helping others, going the extra mile, caring, but what it all boils down to is really serving others because you genuinely want to without expecting anything in return.

Serving others in it of itself is a powerful opportunity to help and when you start to serve others, you’ll realize the simple fact that we all need help and because you realize that, you’ll start to get in the habit of serving others even more. Imagine the avalanche of opportunities that fall into your lap then.

Develop the habit of serving because you genuinely want to, follow through, and you’ll be amazed at the opportunities that come into your life."

Too many of us get stuck in the trap of trying to dish out our help based on what we can expect back in return. The pure opportunities are those where you are not even thinking about yourself and you are helping others that can, in no likely way, return the favor. Help the poor, help the child, help the entrepreneur, pay the toll for the person behind you…you get the idea. It just gets banked in the Karma account. So, "Practice random kindness and senseless acts of beauty", as coined by Anne Herbert…

NBC/News Crash YouTube’s Party

Click on the Buzz in the left rail and you’ll see a piece on the recent announcement about NBC & News Corp partnering to create a YouTube "killer". The labels are slashing about for a strategy as IPTV comes roaring at them. Some, like Viacom, are using the classic sue and ally model. NBC/News are going for the coop model. They never seem to learn to play ball together which is why iTunes kicked their butt the first time. They will need to a) cooperate and b) be hip to draw the masses…neither of which they normally accomplish. My bet is YouTube takes the UGC world, iTunes becomes the channel of choice (aided by the new iTV which gets content to the TV) and Joost/Bit Torrent and crew fight it out in the P2P/streaming world.

Real Estate Is Toxic

When venture capital and real estate mix, something has gone terribly askew. I am not talking about innovative companies like Zillow or Realtor.com but rather old fashion real estate ownership. One of the least understood liabilities for entrepreneurs is their long term lease. Some firms go as far as to sink significant sums into buildouts or outright RE ownership.

The problem is that no matter how you cut it, RE is an unproductive asset to a technology firm but a necessary evil. Every dollar sunk into RE is a dollar that can’t be spent on sales & marketing or R&D. Furthermore, it creates a senior lien to all equity. This gives your landlord control when liquidity gets tight.

Entrepreneurs make a variety of common errors when it comes to real estate:

1) Failure to Understand the Liability Impact: when an entrepreneur is signing a lease, he/she often focuses on the monthly lease rate. While trying to limit the term, he/she is focused on near-term survival often and the lease rate is enemy number one. So, you often see firms locking in 7 or 10 year leases to get the lower rate. For a 20,000 sq ft space, at $18/ft for 10 years, the company has just signed up for a $3.6m liability.  If the company is going to be around for years to come, why is this an issue?
— a) if you sell the company, you are stuck with it and it comes out of the purchase price
— b) if you run into trouble, the landlord is often the largest debtor and will drive the restructuring process.
If you see that you are going to be running into a potential liquidity squeeze (and you trust your investors), make certain that they put a secured, convertible note in place (subordinated usually to bank debt). This puts them ahead of the landlord and gives you leverage to negotiate hard with him/her. The alternative is bankruptcy and the secured note would take the company, leaving the landlord with nothing. Unsecured, the landlord is pari passu and will play hardball.

2) Overestimating Future Space Needs: entrepreneurs are optimists. They tie their RE estimates to their sales estimates. Since they will be doing $15m in year two and $30m in year three, they will need space for 100 people within 36 months. Guess what? Sales don’t ramp as expected ever nor does the headcount. You end up with reams of unused space that you are paying for and frantically have to sublet. As you grow, pack ’em tight and limit stand alone offices. The best insurance is to have a right of first refusal on adjacent space in year 3 or 5.

3) Building the Taj Mahal: pride goeth before a fall. Entrepreneurs sometimes feel that they need to have impressive digs to be taken seriously by perspective customers and partners. I have never seen a company get business because they had impressive office space versus their thriftier counter-part. It is usually because the CEO wants to feel more established and successful. You can always get affordable space if you hunt around. And, be modest in how you build it out.

4) Failure to Use a Good Tenant Rep: I don’t know why all firms don’t use tenant reps since the service is free (the landlord pays out of his side). Also, entrepreneurs pick firms that don’t work either with smaller firms often or don’t deal in the office space types appropriate for an early stage company. Ask your VC or other entrepreneurs who they have had success using.

5) Locking in Rates at the Peak: companies often find themselves expanding and feeling "immortal" during market highs. This is also when lease rates are at their highest. We are seeing a little of this return in the current market. When rates have risen and capacity is tight, be careful about locking in long-term leases and large space commitments. If you have to unload it later, you will get killed on the sublet as rates will drop back down.

6) Insufficient TI: make certain your deal has a strong tenant improvement component ($30+/ft). This helps with limiting your upfront buildout cost, but is also essential should you need to sublet as new tenants will demand it. If you don’t have enough, they will make you pay for it out of your own pocket.

Other random advice…make certain you have a buyout clause in your lease (usually around the 5 year mark). Negotiate down the letter of credit. While it is not cash out today, it will impact how low the bank will let you draw your capital to. Negotiate hard on the # of months for the line or the deposit. And, in general, be Spartan.

I view RE as a necessary evil in the start-up world. I don’t trust landlords further than I can throw them. They need predictability and consistency in their model because of the debt they assume to build/buy buildings. They have little appreciation for the volatility of the technology world and no appreciation for equity. When you get into trouble, very quickly, you can find yourself dealing with an unbending adversary. You need to protect yourself by being conservative in your space assumptions, Spartan in your aspirations and rational in your lease structuring. Religiously try to keep RE costs and total liabilities as low as possible.

Tracking the VC Buzz

Some of you may have noticed that I have a VC Buzztracker list in my left column. My buddy, Al Warms, launched Buzztracker after his investment in and experience with Real Clear Politics. His belief is that analyzing what news items and leading posts get the most links is the best way to identify what has the most buzz or interest in the blogosphere.  Posts/articles at the top of the list have had the most links & references to them from the VC blogosphere. At RCP, they have used this for some time to bubble up the breaking news with the most buzz in the world of politics. He has rolled this out across different verticals, including venture capital.

If you see any posts of interest in the VC Buzztracker secton, feel free to click on that section and you will go the full VC Buzztracker page with all of the articles. I’ll post, from time to time, on articles/posts of interest. You can also go directly to Buzztracker to see Al’s main home page with the top topics on the web.

Thanks to Al for helping to pull this together.

Garbage Social Networks

I have a friend, Frank Gerber, who writes a nice blog called Frankly Green
about environmental issues and things we can all do to improve our
immediate environments. He has me thinking a lot about my daily
routines ranging from driving my car to throwing away trash at our
house. In particular, I have been amazed by the amount of garbage that
we throw out each week…even more so when I think about all of the
houses doing this week after week. I am amazed we can find homes for
all of this. So, enough environmental rambling…

I was also intrigued by the Nike+ program where you drop their sensor
in your shoe and then upload your run data from your iPod to their
community website. You can compete & compare to friends or to
random people around the world. It creates social nets around running.
It got me thinking about this in the environmental sense.

What if you had a similar type of site for different types of
environmental factors. Interested people could, for example, weigh
their garbage weekly and post it to a community site. Being
environmentally friendly is becoming all the rage and people are
competitive by nature while also wanting to be part of community. This
would lever all of the above towards a common good. People could see
how their consumption compares to other families of similar size. They
could have discussion areas where they shared what they were doing to
reduce consumption/waste and best practices. You could embed awards and
such to this. Since it requires weighing your garbage, it is not overly
invasive and people seem to be looking for ways to get green. This is
not an investment idea as I don’t think the purpose should be economic
though you could possible generate some revenue (and donate it).

I believe that it is becoming increasingly difficult to make horizontal
"social net" sites work. The barriers are too low and there is too much
noise. However, using the learned dynamics of community from the first
wave could benefit future efforts that embed social nets into their
solution. I see social nets as a tool or enabler and not necessarily a
stand alone investment concept.

Anyways, this is the random thinking of a VC…

Death to Barney

"I love you. You love me. We’re a happy family…"
  — Barney the Dinosaur

I have found that there is a correlation between either the number of sales "war stories" or the number of sales slides in the board deck and how well the company is progressing. When things are bad, some management will spend 20 slides breaking down the pipeline a hundred different ways. The VP, Sales or the CEO also spends inordinate amounts of time describing the exciting activity at each account. Lot of activity and "really great developments" but sales seem to miraculously fall short of plan by large amounts.

My friend and former portfolio CEO, Juergen Stark, had a great name for these: Barney meetings.
He used to use this phrase to describe fruitless Business Dev meetings with partners. Everyone would talk about how excited they were to be engaged and how promising the future could be and then…nothing, nada, the big zero. Like the purple dinosaur, you could hear everyone singing "I love you. You love me…" with a great big hug at the end.

I say Death to Barney. It is bad enough when a company hits a dry spot and can’t close business. Sometimes it is because the market is not ready. Often, it is because the product has not been packaged and productized properly so it sits like a round peg in a square hole out in the market place. It is even worse if management, instead of fixing the issue, feels compelled to burn significant calories drafting a multitude of sales slides and pseudo victories. And more painful yet, the board gets to sit through this show, knowing full well what sits underneath. No one wins here. So, some thoughts around how to deep six the dinosaur.

1) Keep the war stories to a minimum in summarizing the sales situation. Discuss key events indicating positive or negative trends. Celebrate true & material wins. Point out key losses and lessons learned. Don’t go through 10 account stories of adventure and mayhem. If it is bad, don’t sugarcoat it.

2) Simplify the pipeline section. I find that one slide with names placed under closed (100%), under contract (90%), LOI/contract negotiation (75%) is all that is needed.  Show the game between this discounted total and plan. Don’t cut it by region, by channel, by sales guy, buy astrology sign, etc.

3) Give a realistic pipeline summary. Don’t toss anything in there that isn’t in contract negotiation or near final approval. I hate it when a company throws a whole bunch of 25% and 50% prospects totaling $10’s of millions and then discounts this down. Meanwhile, the 100% and 90% names total a couple hundred thousand. Guess what…the company always misses their numbers since the lower probabilities never come through when and to the degree expected.

4) If you aren’t scaling and your competition is, get an objective perspective why. Don’t get a group hug going around the wonderful war stories and offhanded comments about your competition. They are kicking your butt in the market place for a reason. If you can’t get there, hire a third party to realistically tear into it.

In short, too many executives feel they have to manage their board and keep everyone happy. So, out comes the dinosaur, a lot of smoke goes up around what is really happening and everyone leaves energized by all of the wonderful activity. Forget the last slide that shows the company at 50% of plan. Guess what…time to blow away the smoke, start cutting expenses if needed and figure out why the dogs are eating the dog food. If you ever hear yourself saying "This [setback] is really a good development for us…", stop yourself and smell the roses.

My little daughter won’t be happy but Death to Barney…