VC Board Best Practices

by mbmccall

How ironic…I did a post yesterday about how disfunctional venture backed boards can get and behold, a new white paper "The Basic Responsibilities of VC-Backed Company Directors" from a consortium of venture groups comes out on best practices regarding boards.

"The paper’s basic premise is that VC-backed boards are particularly prone to
dysfunction, due to: (1) Conflicting interests; (2) The regular addition of
new board members following financing rounds; and (3) The likely presence of
inexperienced members like first-time entrepreneurs, junior VCs or
independent directors with strong domain knowledge but no background on
VC-backed boards. Moreover, what happens if one high-profile VC is on a
board with a bunch of lower-profile VCs. Does the high-profile guy always
get his way, because the others don’t want to lose out on the opportunity to
continue co-investing?" (PE Hub)

Interesting read. We will see what uptake occurs on the board assessment tools.

Class Warfare (VC Style)

by mbmccall

The difficulty of tactical maneuvering consists in turning the devious into

the direct, and misfortune into gain.

– Sun Tzu

A number of you wrote me after my post on "The Power of Dry Powder".  Many of you have heard about contentious situations between investors in the same company and were curious about how this comes about. I will lump most of this discussion in the bucket of "class warfare". During periods of "misfortune", many later round investors turn things into gain at the expense of earlier investors.

As a company grows, it takes on multiple rounds of investment. This usually constitutes several "classes" of convertible preferred stock, with each designated alphabetically (Series A, Series B, etc). The founders and angel investors often have common stock which is junior to the various preferred stock series.

Each new round usually has at least one, if not more, new investor(s) to price the round and set the terms independently. The new class of stock is usually senior in liquidation to the series before it. So, if Company A raises $2M of Series A, $5M of Series B and $10M of Series C, investors in Series C get their money first, Series B next and then Series A. If there is enough left over, the common gets the remaining unless it is participating preferred. This means the preferred get their money out and then participate in the remainder with common based on their % ownership in the company.

Different classes with different rights and seniority creates a broad array of misaligned interests:
Acquisitions: If the Company gets an acquisition offer for $11M, the Series C investors might push to sell if they have lost faith in the business. They get their $10M back (and the Series B gets $1M). However, the B and Series A would not want to sell since they get little. If they have blocking rights, they will prevent the sale from occurring. This happens when major decisions (sale, new capital, etc) must be voted on individually by each class versus combined by everyone (pari passu). In the later case, the C would be able to push through a combined vote since its $10M is greater than the $7m from the other two classes combined (assuming simple majority, etc).

New Capital: When new rounds of capital are raised, all kinds of games can begin. If the older investors are tapped out, the recent investors are not overly excited about carrying the company for the free riders. So, they throw in a pay to play. In this situation, old investors have to invest their pro rata (% ownership of the preferred) or their preferred stock gets pushed to common. This means that even if you are a Series B investor, if you don’t invest your full amount, your Series B stock converts to common and falls behind the remaining Series A, B and C stock. This is particularly nasty if there has been a lot of money raised. Let’s say there is $20M in each of the classes and you are a Series C investor. Before the new financing, you needed a $20M exit to get your money back (C comes out first and was $20m in total). If new money comes in (say $10m) and you don’t invest your pro rata, you get pushed to common and now need a $70m (minus your investment) exit just to get your first dollar out (A,B &C are $20m each and the new D is $10m). You then participate with everyone based on your % owned in the company. If you invested $10m and own 20%, then you would get your full money back $50M later. So, before, you needed a $20m exit to get all of your capital out and after the Series D came in, you need a $121M exit ($60m in remaining preference ($70m-your $10m) ahead of you and $50m for ownership).

It is for these reasons, that investors like to have blocking rights on sales and financings. This means that they own enough of a Series (or they and "aligned co-investors") that the Company needs their approval to sell or raise. This prevents a pay-to-play from being crammed down on them.

There are a vast array of other scenarios, but these give you an initial feel for how messed up syndicates can get when a) classes have different rights and b) investors begin to run out of capital. Since angels often don’t have sizable reserves for future rounds (or don’t know to save for them), they often get hammered during these kinds of financings. I have had my share of both sides and can tell you, like at Christmas, it is "much better to give than to receive". In all honesty, though, if a deal starts to take on these characteristics, no one usually wins and most of the manuveurs are like rearranging deck chairs on the Titanic..

Strongest Dad in the World

by mbmccall

Sports Illustrated did a great piece on Dick Hoyt and his commitment to his handicapped son. There is also a link to short video on them on YouTube…

"[From Sports Illustrated, By Rick Reilly]
I try to be a good father. Give my kids mulligans. Work nights to pay For their text messaging. Take them to swimsuit shoots.

But compared with Dick Hoyt, I suck.

Eighty-five times he’s pushed his disabled son, Rick, 26.2 miles in Marathons. Eight times he’s not only pushed him 26.2 miles in a Wheelchair but also towed him 2.4 miles in a dinghy while swimming and Pedaled him 112 miles in a seat on the handlebars–all in the same day…."

The Myth of 51%

by mbmccall

One of the greatest misperceptions in the early stage entrepreneurial world is that control revolves around maintaining greater than 51% ownership in a firm. In many term sheet negotiations, I have seen entrepreneur after entrepreneur focus intently on maintaining majority ownership. While this is key for buyouts when the company is cash flow positive, it is not the key factor with venture deals. How so???

In talking with friends who have flown commercial aircraft for the main carriers, they all comment that their job involves doing things right for about 5 minutes at take-off and 5 minutes at landing. Not much action occurs otherwise (usually) during the rest of the flight. This is similar in the venture business. The majority of change, power plays, management turnover and such occur right around financing events. The rest of the time is just build up to these main events. When a company is burning cash and runs out of cash, it doesn’t matter if investors have 5% or 55%, this is when they have significant voice in the running of the business.

New investors will generally not come into deals if existing investors are not participating (insiders know more than they do and must have issues with the company if they are boycotting a financing). New investors will often come to many of the same conclusions that existing investors have about a business model, a management team or competitive situation.  So, if there are any disagreements between an entrepreneur and his/her investors (especially if the entrepreneur refuses to acknowledge or strongly disagrees), they must be resolved before the new capital comes in. Investors may be concerned that the burn is too high and the entrepreneur, hoping success is just around the corner, has his/her foot on the gas pedal. This is why you often see RIF’s and other cost reduction efforts around financings. You also see new CEO hires occuring around financings (granted most of these are with the mutual consent of the entrepreneur and investor).

Later stage investors and buyout firms will often demand 51% ownership and board control because the firms they invest in are cash flow positive or have the ability, in short order, to become self-sufficient. Without legal control, they lose their voice at the table. However, early stage companies need to realize that ownership does not drive the leverage. Of course, they will want to hold onto as much ownership as possible for economic reasons and for when they are cash flow positive. But, they should not expect this ownership to have much impact on their relationships with investors. Mutual respect, alignment of interests and cash flow are the key drivers.

Later this week, I will do a post or two based on some emails sent to me by readers about how power plays develop within the investor syndicates themselves and how this impacts the company.

The Option Fallacy in Recruiting

by mbmccall

"You better cut the pizza into just 4 pieces because I couldn’t eat 8"
— old punchline

I was out at dinner tonight with a number of local CEO’s and VC’s and the topic of options during recruiting came up. The consistent theme was that employees, in comparing offers from different firms, look at the number of options versus the value of the options. So, in a comparable economic transaction, if Company A had issued twice as many shares as Company B, it could offer 10,000 options as an equivalent to Company B’s 5,000. And, many recruits would find A’s offer more attractive even though they were worth the same (assuming similar preference, market/strike price differential, etc).

My experience has been very similar. An employee will view a 1,000 option grant more favorably than 500, and 10,000 more so than 5,000. Assuming that you don’t end up with a silly number of shares outstanding, you can reach your target level by using stock splits. If your average grant is 500 and you want to hit 1,000, doing a 2-for-1 stock split will get you there. It is easiest (and more affordable) to do this during a financing when the lawyers are already redrafting capitalization numbers.

My advice to employees is to avoid the warm glow of this option trap and do the following quick math:
First, you need to collect the right info. Ask your potential firms for the following…amount of preference & debt, see if the preference is participating, number of fully diluted shares, last market price and current option strike price. To figure out the value of your stock:
1) multiple the last market price times the fully diluted share base (equity value of firm)
2) subtract out the preference and the debt from this amount (remaining "common" value)
3) if the preference is participating (investor gets back his/her preference and then participates as if they had common shares), divide your share grant by the fully diluted share amount (your "ownership" percentage). If not, then back out the preferred shares from the fully diluted number (or don’t subtract out preference in #2 above).
4) multiply your percentage times the "common" value to determine your take
5) subtract out the cost of exercising the options (strike price times # of options)
6) this resulting amount is your take at recent market.
You can run this exercise for higher values to see how you would make out at other acquisition prices. You can compare the offers on an apples-to-apples basis. It is possible that a 100 option grant is worth more than a 10,000 grant at another firm.

Entrepreneurs should remember, on the other hand, that there is a psychological hurdle in getting options above 1,000 and even more so above 10,000. Seems silly but it’s true…

The Power of Dry Powder

by mbmccall

One of the hardest things to manage in early stage venture capital is asset allocation to specific investments across the portfolio. You strive to maintain diversification by investing across 20+ investments and hope that you maintain adequate reserves to support your companies, can get enough capital into your winners and avoid plowing prodigious amounts into your losers. However, things never seem to work out as planned and you end up with a wide divergence.

Let’s look at a model portfolio. Let’s say you raise a $115m fund. Off the top, you take out $15m in fees over the life of the fund. This leaves you with $100m. Your average fund will try to invest in 20 to 25 deals to get adequate diversification, so they would target $4-5m per deal. In a perfect world, you accurately assess the capital needs and take downs across each investment and you hit your target. (actually, perfect world would be you identify losers early and under-allocate). You invest 30-40% of your total allocation to a deal in the first round and hold back the remaining 60-70% for follow-on rounds.

You can always tell new investors to the business since they have not seen their share of cram down rounds and carnage. So, they put in 50-70% of their allocation up front since the valuation is low. Why not grab a bigger share of the business and then dilute down over time? They find out the hard way. At some point, they run out of dough (usually the second round). If the company has failed to hit self-sufficiency at that point, they are now relying on the kindness of strangers for capital. In this situation, it is only a matter of time before existing co-investors put pay to play provisions in, remove anti-dilution rights and such for any existing investors that don’t do their share (their "pro rata") of future rounds. They don’t want to have free riders tagging along.  If you don’t have reserves ("dry powder"), all of your investment potentially gets pushed to common and all of the remaining preference comes out before you. Life is pretty ugly, especially if a couple of preferred rounds then come in on top.

There are two scenarios that are sub-optimal:
1) Big winner, not enough capital in: your company does really well, really quickly and you only get a fraction of your allocation in. So, you targeted $5m per deal, invested your 30% ($1.5m) and then the company never raised additional capital. If it does really well (say 10x), then you pull down $15m. This, unfortunately, will only pay for 3 complete losers which you may have had ample opportunity (unfortunately) to get your full $5m into.
2) Drawn out loser, too much capital in: so, you learn your lesson, you are determined not to have too little into your deal, you put 50% in ($2.5m). Things don’t go as planned and next thing you know you have $5m in the company and are staring at a cram down. You have to put another $1m to prevent a pay-to-play (support your pro rata or go to common). This deal eventually drifts sideways and maybe you get 25% back ($1.5m back, losing $4.5m). Damn, you just can’t seem to win.

In the end, you are much better off risking #1 than #2. At least you are complaining that you only made $15-20m on the deal. In the other case, you are potentially looking at getting squeezed down to nothing if you can’t defend yourself. So, as a rule of thumb, don’t get greedy. Make certain you have dry powder (or if you are an entrepreneur, make certain your existing syndicate has dry powder to see you through hard times). If you fail to reserve, existing investors will hit you with a pay-to-play and new investors will crush you on price since you don’t have an alternative. This means putting no more than 25-30% of your total allocation up front, and make certain you have reserves to meet pro rata needs. This also means that as you start to run low, you better get the firms burn down so that your pro rata will be of a smaller number (need to raise less money).

In the end, you can see how allocating capital optimally is more art than science. You set general parameters, but because of the uncertainties regarding timing, ramp, burn, etc, it is very hard to know what the ideal commitment is to each round. Given a choice, I would always lean more towards fear than greed.

Multiples vs IRR

by mbmccall

I was at a business school today helping judge several business plans. As group after group presented, I saw each make the same mistake as the previous. When they tried to justify the investment from the perspective of the VC, they kept telling us that this was a 40% IRR deal or a 25% IRR as if we had magical IRR thresholds.

The reality is that the venture world is all about multiples and the IRR’s are the results. I don’t know what the original legacy behind this was, but from a practical perspective, it is driven mostly by the fact that we live in a boolean world. Some is also based upon the high net worth legacy of our business. Originally, because pension law did not permit the large institutional investors in, our business was funded by family offices, endowments and foundations. Multi-generational families, while they want high IRR’s, are really looking to double or triple their invested capital.

From a portfolio perspective, if we invest in 10 deals, 4 are tube shots, 2 we fight to get our money back on, 2-3 we get 2-5x on and the 10th deal drives the return (hopefully north of 10x). If we doubled our money in 1 year (100% IRR) but lost all our money on the next deal over 6 years, we aren’t happy (net gain is $0). We don’t care that we made 2x in 1 versus 3 years or lost all of our money over 6 years versus 4 years (this impacts IRR), because we earned 1x on the capital.

We often see complex financial models with discounted cash flows, hurdle rates and such. These are useless. I have never seen a set of financials in an early stage company that ever reflect what Darwin will allow to happen in reality. So, you start your modeling with unreliable numbers. Secondly, what is the beta for an early stage biotech deal, a semi-conductor start-up, etc? Can you assess the risk associated with a given management team? How about a new market space?

Perhaps we are too lazy to try and figure this out, but after decades of effort, the only method that seems to work in the venture world is to target 10x on each early stage deal (3-5x on later stage plays). They all look like the next Microsoft, but eventually, the portfolio of these settles down to the profile above. In the early stage world, if you target, say a 40% IRR, through assuming a number of 5x wins in a compressed period of time, you will likely be out of the business. Your 5x wins, while possibly generating high IRR’s, don’t return enough multiple to pay for the 4 tube shots and 2 break-even deals. Your winners need to deliver 10x.

So, next time you are trying to convince a VC about the merits of your firm, show them how they can make 10x capital on a realistic exit scenario (not how to get a 40% IRR).

Gates: The Way We Give

by mbmccall

You are increasingly going to hear me write about Venture Philanthropy and Social Entrepreneurship. I see a blending or cross over starting to occur between the venture/entrepreneurial world and the philanthropic one. Both sides can benefit from approaches and axioms of the other. Just as in our economy, you need to continually innovate and find new technologies and approaches for old problems, the same is true for the non-for-profit world.

In a recent Fortune article, Bill Gates: The Way We Give, Gates lays out a variety of elements that drive his philanthropic approach. To begin with, he starts by saying that it is philanthropy’s job to step in when market forces don’t. He also believes in the power of using technology to improve people’s life. Just as in the for-profit world, the best chance to make an impact is when you find a problem that’s been missed and you can develop a new approach and bring new resources to bear. Malaria is an example where the market mechanism breaks down:

"Take Malaria, 400m infected, 1m die. 2,000/day. You develop a technology when there’s a buyer for it. Here there was no market for discoveries in fighting malaria. Philanthropy can draw in experts, give awards, novel arrangements private companies, partner with universities." (sounds a little like active venture capital…)

He also hits on a them that I have noticed. It is not that people don’t care about the poor, but rather, the poor are not visible necessarily (nor impact) people’s daily lives. As Gates says:

"Randomly resorted world, rich people lived next to people in developing world conditions, you’d walk down your block and say, “Those people are starving. Did you meet that mother over there? Her child just died.  Do you see that guy suffering from malaria? He can’t go to work.” Basic human instinct would kick in and we would change our priorities.”

We also try to over engineer solutions. "Best technology is often the simplest. Heat-sensitive stickers prevent millions of doses of good vaccines from being discarded".

Lastly, just as venture investments need take outs from either the markets or large corporations, philanthropy, in the end, needs businesses and governments as partners. This is where the big capital is. I’ll write at some point about a mentor of mine, Irving Harris, who used to use his own capital to develop new approaches to solving old issues, roll out programs, measure them and migrate them eventually over to larger, government funded programs. As Gates say: "That means we need to get these issues on the political agenda…government has to be involved in solving them. Gates is 1% of the giving in America…which equals only 50% of what the state of California spends on education each year."

It’s an interesting article and worth a read.

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