Where Does Power Lie

by mbmccall

"In conflict, be fair and generous.
In governing, don’t try to control."
   — Lao Tzu

John Ketchum, who runs Corporate Programs at our portfolio company TicketsNow, reminded of this quote which is most relevant to yesterday’s post. Underneath all of the legal wrangling and finger pointing there lies a basic question: Where does power lie in a venture board?

After many years in the business, I have two rules about this:
1) as long as the company is burning cash, the VC’s have significant leverage.
2) entrepreneurs have as much power as they have alternative funding sources.
2) VC’s that feel inclined to run a business are in for a rude surprise in the end.

Most entrepreneurs focus on maintaining 51% or more of the voting stock with the belief that this will give them complete control over the company. Unfortunately, this is not the right place to look. It rests in the cash flow statement. You will notice that all major issues and changes occur around funding events. If a company needs capital, it must first turn to its current investors to determine their appetite and desire to continue supporting the company. If they are not happy with the company or with their relationship with the CEO, they can elect not to invest. If inside investors do not invest, it is often difficult to get new investors to come in. Furthermore, if the situation is so dire that old investors won’t re-up, then it is unlikely that new investors will see the situation differently. With the company burning cash and no place to turn, inside investors can name the terms under which they will reinvest. This can include changes in strategy, personnel or execution.

Even if the VC’s own 5% of the company, this need for capital is the source of their leverage. Entrepreneurs that can get their companies to break even, or that have alternative funding sources, have a much stronger position. By the time a company has had a couple of down rounds, it is usually in pretty dire straits. Even if the VC’s exert influence at that point, they are usually just rearranging deck chairs on the Titanic. No one wins and the VC’s end up with a bad rep.

I want to point out that it is not be the VC’s job to run the business, but rather to provide resources to it. No matter how knowledgeable, a VC usually can not know more about a business/industry than the CEO. That CEO lives in that job 24/7 while the VC simply visits it during the month. If the VC backs the wrong CEO and find him/herself continually questioning the judgment of the CEO, then he/she made a poor call in originally investing. Younger VC’s can often micromanage a deal due to nervousness and naivete. Some short-sighted VC’s can also demand certain changes, not because it is right or fair, but because they can. Fortunately, most VC’s are pretty descent and fair.

Good VC’s will give an entrepreneur significant room to operate, will give advice based on past experience and will bring resources or connections to bear as required. He/she will layout core principles or constraints which are important to them as well as define, with the company, critical milestones. Control is not determined by legal clauses or purse strings but, hopefully, by mutual, earned respect between them and the CEO. If law or finance is the basis of the relationship, then much has already been lost.

In short, investors’ influence and power wax and wane during the business cycle of a firm. It is highest when cash is dear. However, it is a mistake for VC’s to enforce unilateral control on a business since it poisons the relationship going forward (mutual assured destruction). If this force is necessary, then things have usually hit a pretty dire situation and the CEO will also have considerable responsibility for the resulting consequences.

A Dark Side Tale

by mbmccall

Entrepreneurs have heard an array of warnings about the VC dark side. After toiling to build a business, it is snatched away by the investors. However, few can point to a specific example. I’ll try to forward on examples going forward with the goal of showing that often, these stories are a two person dance (not just one evil one).

The following link, Accel and Levensohn Get Rapt lays out the details of a current lawsuit regarding such a case. Daniel does a terrific job, as usual, laying out the specifics.

The key takeaways for me are:
1) If you raise a considerable amount of institutional money and yet, over a period of time (years), are unable to deliver results, bad things will likely happen.
2) If you have run the business such that no new investors are willing to come in (and even some existing ones don’t re-up), you a) are very vulnerable and b) have basically sucked most value out of the firm
c) if after doing the above and you elect to leave the sinking ship, you should expect remaining management and investors to reallocate the pie
d) if you do all of the above, litigation will only worsen your situation. Unless the investors have truly acted fraudulently, you are not likely to win the case and worse, few new investors will likely back a litigious entrepreneur.

So, in short,
1)don’t raise enormous amounts of capital (less than $10-12m if unproven)
2) Focus on your core milestones and hit them
3) If you miss, keep an open channel with your investors. Honesty and frank communications goes a long way.
4) Don’t have unrealistic expectations if you take on considerable capital and flatline the business. There often is no value and later round investors are basically rolling the dice that something can be salvaged.

Sorry About the Font

by mbmccall

Sorry that the microscopic font keeps slipping into my posts. I will do a better job double checking in the future. Both Greatest Fear and Crystal Ball had fonts that were unreadable in most readers due to size. I have changed them (which doesn’t help with the feeds already pushed out but will on the site).  Elvis is back in the building…

Our Greatest Fear

by mbmccall

I saw another great movie this weekend with the wife and kids called "Akeelah and the Bee". You have probably either seen it or at least read about it in the papers. It is the story of an 11-year old girl from the poorest region in South LA who strives to win the national spelling bee. There is a lot of good stuff in it for both entrepreneurs and for young kids about perseverance, overcoming obstacles and addressing fears. One of the greatest fears that we all deal with is the fear of failure. Whether it is the child preparing for a tournament or test or an entrepreneur launching a business, fear continually nips at your heals. Lawrence Fishburne had an awesome quote on his wall in the movie for inspiration. I thought of all of you future Sergey’s and Jobs’s…

Our Greatest Fear

by Marianne Williamson from her book “A Return to  Love”

Reflections on the Principles of A Course in Miracles 

Our greatest fear is not that we are inadequate,
but  that we are powerful beyond measure.

It is our light, not our darkness, that frightens us.
We ask  ourselves, Who am I to be brilliant,
gorgeous, handsome, talented and  fabulous?

Actually, who are you not to be?
You are a child of God.

Your playing small does not serve the world.
There is nothing  enlightened about shrinking
so that other people won’t feel insecure around  you.

We were born to make manifest the glory of God within us.
It is not  just in some; it is in everyone.

And, as we let our own light shine, we consciously give
other people  permission to do the same.
As we are liberated from our fear,
our presence  automatically liberates others.

But Isn’t It Just Like…

by mbmccall

"This is like deja vu all over again."
      — Yogi Berra

Boy is it getting crowded and noisy out there. People, desperate to get a piece of the new gold rush, are leveraging the low cost, commoditized internet technologies to throw up all kinds of niche web 2.0 plays. This obviously will not end well. So, WHAT IS AN ENTREPRENEUR TO DO?

I have a pretty simple test for a new idea. If you describe it to friends or knowledgeable people, if they respond: "nice idea, but isn’t it just like…", time for a new idea. As Ross Levinsohn who runs Fox Interactive said, "Don’t copy the original; be authentic."  As he said, My Space was not trying to be Yahoo. Yahoo does a great job as an aggregation portal. He pointed out that Yahoo has repositioned their video service to look like YooTube. Not a good idea, and a reason that Yahoo will likely have to buy YooTube in the end.

Find unique spaces, strategies, verticals and approaches. Innovation and market leadership are rewarded in the technology world. Imitation, unless you are Microsoft, are not. Also, make certain that your execution is spot on and consumers get satisfaction in the most straight forward manner. And, listen to your friends and others…Isn’t it just like xyz?

eVenturing.org: Entrepreneurial Resources

by mbmccall

The Kauffmann Foundation is know for being the most active non-for-profit funding entrepreneurial activities, studies and projects. They have rolled out a resource site for entrepreneurs called eVenturing
. This site has a collection of resources from aggregated blogs to surveys to "how to" reports on HR, marketing, finance and other core areas key to entrepreneurs. Lot of stuff on this site, so you will have to cut through it to find what is relevant to you, but I was impressed with what they had put up there. You can also subscribe to different feeds including different "perspective" pieces from leading entrepreneurs.

Definitely worth a look…click on the link above.

The Math of Dilution

by mbmccall

One of the follow up questions from two days ago was: so how much should I expect to own at the end of the day? It all depends on how capital efficient you are. If  you need to raise $5M followed by $15M followed by $20M, there is not much pie left at the end of the day. Let’s see what that looks like:
    Seed/early    $5M at a $5M pre-$ leaves you with 50%
    Expansion   $15M at a $15M pre-$ leaves you with 25%
    Later stage  $20M at a $40M pre-$ leaves you with about 16%
    Back out 8-10% for equity to other managers, warrants, founders, etc and you have 6-8% left over

Unfortunately, too many entrepreneurs don’t think this through completely and are extremely resentful or disappointed at the end. Furthermore, if things don’t go as planned the money could come in at much lower valuations or you might need to raise more rounds.

In a capital efficient play, you end up with a much greater share. For example:
    Seed/early  $1M at a $3M pre-$ leaves you with 75%
    Expansion  $3M at a $12M pre-$ leaves  you with 62%
    Later           $3M at a $27M pre-$ leaves you with ~56%
    Back out 8-10% and you have over 45% still in your possession. You’ll notice that I even used lower pre-$’s in this second example and it still came out significantly ahead (nearly 7x).

What out for that burn…

Funding Life Cycle of a Firm

by mbmccall

"I don’t know where I am going, but I’m making great time"

On of my readers in Germany sent me an email the other day asking if I would describe what the funding cycle looks like…timing, amounts, valuation, etc. While there are millions of permutations of this, I’ll try to give a general framework and set of principals.

Start at the End: you need to understand what self-sufficiency looks like for your business. Until you can support yourself (CF positive), you will be reliant on the kindness of strangers and will be in perpetual fundraising mode. Your knowledge of your business model is key here.

Layout the Steps: How much capital does it take to get to self-sufficiency and what are the key milestones in the business. Some that VC’s use are:
1) getting your beta launched
2) getting the production version launched
3) getting your first "high profile" customer that others in the industry take notice
4) hitting $3-5M in sales (usually means you have figured out pricing)
5) hitting $10M in sales (usually means your direct sales force is working)
6) hitting $20M in sales (usually means you have channel down)
7) EBITDA positive
8) CF positive.

How much capital do you estimate it will take to hit these and when? Then double each amount and the time (law of 2). That is a rough estimate for your needs. I would say that you generally have a three round cycle at a minimum.  #1, #3, #4 and #6 are possible funding events (probably either #1, #4 and #6) or (#3, #4 and #6). We joke about companies running out of letters in the alphabet for rounds (Preferred Stock Series Y) because they have raised so often, but it is usually rare to go past F or G (6 or 7 rounds).

Determine Funding Sources: For each stage mentioned, it will be clear what options you have given the milestones hit and the amount needed. For amounts below $1M, bank debt, customer financing (prepaids), angel or venture are all possible. For amounts, $1-3M, angels and venture are possible and for amounts above $3-5M, you are dancing with the VC devil. Usually, you see bootstrapping and angels to get to beta or first customer, and either angels (if really capital efficient) or VC’s from there.

Set Expectations Around Valuation: Entrepreneurs are optimists by design/necessity. Unfortunately, this often leads to huge discrepancies regarding valuation expectations. You should expect:

Pre-product VC seed rounds: $1-3M pre-$ valuation for (this bumps probably to $2-6M for angel).
Beta/Initial customer: expect $4-7M pre-$ valuation (angels as high as $10M)
Revenue $3-5M: expect $7-15M depending on growth, story, sizzle, etc
Revenue $10M: expect $10-25M same caveat
Revenue $20M+: expect $30-60M same caveat

VC’s target 10x for the early stuff (including $3-5M in rev) and 3-5x for later stuff ($20M+ in revenue). So, the visibility of your growth and likely outcome will determine valuation. Can they get 5 or 10x at that valuation?

Avoid Surprises: Fundraising is only as successful as the accuracy of your capital needs estimates. In the worst case, you run out of capital either a) suddenly or b) before you have reached key milestones. In these situations, you lose all leverage in the process and it does not end well. We have CEO’s who develop hives if they have less than 1 year’s worth of runway. Assume it will take you 6 months to close on a round…give yourself 6-8 months to get it done.

Two’s Company: The optimal situation is to get three funders to the table for your process. Assume that one of them will drop out unexpectedly which will leave you with two.  This creates a built in stalking horse/forcing mechanism. Nothing like urgency/scarcity to accelerate the process.

You are  in the risk mitigation business like an insurance company. You are only as successful as you are accurate in identifying risks that get in the way of your plan. Put buffers and contingencies in place (cost reduction or other funding sources) to address surprises. And let ‘er rip…

Crystal Ball

by mbmccall

"Prediction is very difficult, especially if it’s about the future."
       –Nils Bohr, 
Nobel laureate (yes using this one again!)

Having made the error of writing about politics, I am now going to stick my neck out and make a prediction about our upcoming economy. Many would argue that the best way to make money is to invest under assumptions directly opposite of mine… So, here goes.

I have been trying to figure out what impact falling home prices would have on the economy — recession, deflation, etc. While reading a recent Economist article, it struck me. We are staring into mouth of stagflation driven by rising wage pressures and rising interest rates. Here is my thinking (and a good amount from Mark Faber of the Doom Gloom Boom Report & Barron’s fame).

As home values drop while interest rates rise, people will be able to take less out of their homes. This will put increased pressure on the average household which has seen its real wages fall since 2000. With this buffer source of funding depleted, workers are going to put pressure on employers to raise salaries. Corporate profit margins are at an all time high, so it is unlikely that either productivity or outsourcing overseas will give companies relief.

The US government can not let deflation take over or the over-levered average American will go under. So, it will continue to man the money printing presses. This, along with wage pressure, will begin to drive prices up (and profits down).

Having lived in Southern California during the defense recession of the 1980’s, I saw first hand that housing markets don’t crater. They just go illiquid as people refuse to sell at the lower prices. For sale inventory grows, but only the truly desparate sell. So, housing prices drop moderately and there generally is no wide spread panic of plummeting housing prices, retail collapse, etc.

So, as an entrepreneur, go after labor saving solutions. Don’t go after heavy capital equipment type plays (not good in high interest rate environments). Provide solutions that allow firms to operate remotely or, better yet, virtually so that they don’t need to hire permanently. Peter Drucker predicted that in the next 25 years, most firms would only formally employ 50% of their FTE’s. This will require significant infrastructure to do. It also means that there are tremendous process outsourcing opportunities (vertically focused SaaS plays). Any consumer plays will favor the lowest cost producer since real wages will be under pressure as inflation hits.

Enough said…now build or invest assuming the opposite!!!

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