"I am out here for you. You don’t know what it’s like to be ME out here
for YOU. It is an up-at-dawn, pride-swallowing siege that I will never
fully tell you about, ok?"
                                  — Jerry Macguire

So, you all keep reading about how much money is floating around out there and how dysfunctional our business is becoming and yet, you are hitting wall after wall raising money. What the hell is going on? When is someone going to Show You the Money?

The Knife Edge: Here is the truth…raising venture capital is boolean. There is a knife’s edge (pretty dull) and you either fall into the a) next New, New Thing bucket or b) "Yes, But" bucket. In the New, New Thing bucket, you are the market leader (or #2 or #3) in a hot space that is going to be worth $10B according to Gartner. Your analogs are getting snapped up for $600m by News Corp or maybe you go IPO. VC’s are stumbling all over each other and you will likely raise too much money at a wacky valuation.

Yes But: Or, you are like vast majority of the real world, you are in the "Yes, But" bucket. This means, you start many of your presentations with "Yes, XYZ is in our space, BUT we have a better solution" or "Yes it is difficult to sell to municipalities, BUT we have a new, proprietary approach". In other words, you have a promising company in either a traditional or emerging space and while you are better than the incumbents/competitors, it is noisy and outside parties can’t readily discern your market leadership. You have steak but no sizzle. To make matters worse, you are probably selling into markets that have traditionally spooked investors (municipalities, insurance co’s, doctors, hospitals, manufacturing, etc).

Listen: So, what are investors going to do? They are going to look at your business. They are going to tell you that you have something promising and to stay in touch. And then, they will give you (if you are lucky) a handful of "issues" that need to be overcome. This could be showing that doctors in a region will adopt your service in mass or that insurance agents will use your tool (in numbers). In other words, they will give you milestones. Instead of ignoring these (because the VC doesn’t understand your model), take them seriously. Creating a plan that allows you to start addressing these in a capital efficient manner.

Know yourself. Be prepared for this brick wall if:
1) a lot of the efforts before you ended up in the graveyard or scaled slowly
2) there are few large companies doing what you are trying (scalability)
3) there are large incumbents with predatory practices in your market
4) your customers are not easy to sell to
5) other efforts have had to raise significant sums to get to the finish line

Show Me the Money: How do you raise capital in these situations? Couple of ways:
1) strategic capital: if there are customers who love what you do, some may be willing to prepay for services or even invest in the firm
2) angels: friends, families, businessmen from the industry, etc who believe in what you do. Lock down on lead (say $500k+) and the rest come around.
3) placement agent: if you are raising enough money, institutional sources are possible. They will likely introduce you to the same hedge funds and venture capitalists that you would have gotten to. Don’t expect any magic investors that are "unique". However, it saves you the time and effort of running the process. As my friend, Patrick Dealy say "spend your time making money vs. raising it".
4) sector focused funds: find VC’s that have been active in the space. Look at firms in your general space and see which funds put capital into them (avoid those funding your competitors).

Patterns: So, realize that for the vast majority, this bubble isn’t going to make your life any easier. It only applies to the funny money deals. It may mean that there are more angels coming out from under rocks (which is good). And, don’t let it frustrate you. Realize that the investor business is about pattern recognition. If you look too much like something that was previously painful, it is hard to change opinion without proof points. Good Luck.

The good times are back and the money is flowing. Angels are writing $3m checks, Hedge funds are writing $50m checks and VC is a low risk investment class again. Valuations are shooting up. For an entrepreneur, this should be a dream come true.

I would argue, that if not careful, entrepreneurs are setting themselves up for a fall later on as we saw in the last bubble.

There is a reason that many of our most successful tech companies were started in downturns. They had to maintain discipline and be capital efficient. When money and valuations are loose, so, often, are entrepreneurs discipline. Why should you care?

Let’s look at some recent IPO’s.
Vonage:
$ in — $396m
Post VC IPO Value — around $400m

Restore Medical:
$ in — $40m
Post VC IPO Value — $53m

Novacea
$ in — $122m
Post VC IPO Value — $93m

Pension Worldwide
$ in — $35m
Post VC IPO Value — $73m

IPO’s are supposed to be the big wins. If these are returning 1-3x, imagine the other deals.

VC’s usually invest in Preferred Stock. This means they get their money out ahead of common/founders in a sale (IPO’s are different). In fact, 74% of deals in Q1 had participating preferred which means the VC’s get their money and then participate according to ownership.

Exits have been weak for some time. Getting through a big pref stack (total $ invested) is not easy. Furthermore, if it looks like the VC’s are going to have trouble getting their money out, management’s life grows unpleasant and turnover often results.

It is difficult to show restraint when you have a war chest burning a hole in your pocket. Just be careful not to fill the punch bowl too high… On the other hand, make certain you have the long term capital you need. Remember that as tempting as pre-$ angel money is today, the road is long and hard. Projections rarely pan out. If you under-capitalize yourself by taking on a weak syndicates (e.g. not deep pockets), you risk getting crammed down or worse in downturns. Everything is rosy these days and most entrepreneurs feel bullet-proof. Just make certain that you are wearing Kevlar and not a play vest…

On June 29th, I was fortunate enough to moderate the TiE event on Capital Efficient companies. Mike Domek of TicketsNow, Lucas Roh of Hostway and Jason Fried of 37Signal were the entrepreneurs. David Dulka’s post on the event captures a lot of the key points and dialog from the evening. I was incredibly impressed by what all three have been able to achieve. Mike Domek has built TNow into the most visited secondary ticket site in the world off of an initial $100 investment. Lucas Roh built his $100 million hosting company from cash flow (remember the hundred’s of millions Exodus spent?) and Jason Fried has over 500,000 people using his services with only 6 employees. Feel free to catch the specifics from David’s notes. (thanks David)

"If we can sell one to everyone in China…"
                                            — Many a hopeful entrepreneur

Entrepreneurs often ask what VC’s look for in a business. While simple at first notion, it can be complex in detail. One of the key factors that VC’s look at (and which entrepreneurs should seek regardless of funding) is scalability in their business model. This term gets tossed around rather lightly but few people ever take the time to define what they mean by scalability. While different people have different definitions, my basic measure is simple: P * Q.

For all you Economics majors, you know that this is Price * Quantity = Revenue. Why do I say P*Q versus simply Revenue? It probably goes back to my early days at the Boston Consulting Group where you had to break down your analysis to the most relevant atomistic level. VC’s need to see businesses that have the ability to get big. They can do this one of three ways…lot of Q, high P or both.

In pitching a VC, never use phrases like "Gartner estimates this market to be $xx billion…". This will get you quickly escorted out of the building. These numbers are often useless and misleading. Top down approaches give very little visibility into the credibility of a business plan. Avoid "all I need is 2% of this market". Again, top down doesn’t work. First, you are probably relying on the useless analyst market estimate and multiplying by 0.02. Second, you need to be the market leader in your space to cut through the noise and grow. If you have 2% of the market, either you have defined the market too broadly or your market share is somewhere way out on the tail.

Two phrases to focus on: bottom-up and P*Q. When sizing the market, identify the relevant and believable Q. How many customers are you really going to sell to? It often is useful to identify the first vertical or two that you plan on penetrating (technology usually takes hold a vertical at a time). It is much more believable (or defendable) if you are targeting the 2,000 trade associations than it is to target the Wilshire 2000. You can describe what it is about trade associations (or what other vertical) that need your product.

Once you have defined Q, you then need to demonstrate, realistically, how much each Q/customer is willing to pay (P) annually for your product or service. It should be tied to what customers are currently paying for your product or service. If you are selling something for $5,000 a month, don’t model out $200,000 per year per customer. Show that it works at $60,000 a year and that it is gravy when it goes to to $200,000.

Another key factor in gaining credibility with your model and business…visibility. The easiest way to show visibility is to have a credible pipeline. To the degree that the customers in your pipeline look a lot like the customers buying your product, the more credibility your claims will have.

Also, if management has sold to Q in the past and has strong relationships, it enhances credibility that it will work again this time.

So, drive your models to the most basic variables for a bottoms up analysis. Break P & Q down into their sub-components…Q could be visitor traffic times conversion. Each situation has its own drivers. This way, you don’t have to sell one to everyone in China…

There is a lot of press and buzz going around about the rise of the capital efficient start-up. These companies do not need venture capital and hence are free to grow their businesses unencumbered by some Stanford MBA, Mensa venture partner. Ironically, I am moderating a TiE panel this Thursday called "Capital Efficiency for Growing Businesses" (<- click here to register…self-promote!).

Other than control, another reason most entrepreneurs should consider bootstrapping or other non-VC approaches is the trend regarding exits. Historically, 20-30% of VC backed companies went public. Now it is less than 10%. This means that the wins are smaller and it is more difficult to get the VC capital the returns they seek (plus VC’s are raising larger funds and yet again, pumping $10-20m chunks of capital into companies).

Last year, there were only 56 IPO’s of venture backed companies in the US market, down from 93 in 2004 and only 10 IPO’s in the 4th quarter. As of March, there were only 25 companies in registration.
Additionally, more and more bankers and firms are talking about listing on the AIM (Alternative Investment Market) which is the Nasdaq of Europe. Due to the cost and regulatory complexity created for small firms by SOX, the US is losing its position at the heart of the capital market. This is driving IPO values down, and with it, M&A valuations as well. Without the IPO stalking horse, acquirers have less pressure to pay up.

Larger funds are starting to come back into vogue. Many funds cut their size from $800m-$1B to around $400m. Now they are back with $650-700m vehicles. Since the average IPO has hovered around a $180m valuation, it is nearly impossible for a fund to generate 10x on these wins if they have pumped $20m into the deal (unless the average pre-$ was -$2m). This will drive returns down on larger funds that continue to drive larger sums into portfolio companies.

This will be a mess eventually. Avoid it or take smaller amounts of capital ($3-7m). As Seinfeld famously stated: "Become master of your own domain…"

A while back, I asked for feedback from the community on potential topics of interest. One email had a host of questions around founders’ equity. I have been negligent in responding (I hope better late than never!). Great questions and ones that come up often.

1.  How should founding teams allocate equity amongst themselves?  What is the VC viewpoint on how this should be done?

I am not certain how other VC’s feel, but I like to see the various members of the management team have enough equity each that they a) think like equity holders versus just salaried employees and b) are excited to come into work each morning to build value for themselves. The core founders will clearly have the lion’s share of equity. A founder should think about carving out 10-15% in an equity or option pool for the first wave of hires. These shares can be either stock grants with reverse vesting or options that vest over 4 years. The core founders can divide the remaining portion equally or based upon perceived value being brought to the game. Equal division for the core allocation creates the most "egalitarian" approach though it might not be the fairest one.

2. Many software startup founders now do the seed round themselves
and get to a working prototype. How should the money invested be
treated?

A number of my friends have asked me this question when they are starting up. I would first divide up the equity pre-$ according to the discussions in question 1 above. Once that is set, determine a value for the company (most likely between $2-5m) and let the money buy an ownership stake. A simpler approach so as to avoid the potentially contentious pricing of the firm by founders is to have the money come in as a convertible note that converts at the same terms as the first professional money. This works if a venture or angel round is likely in the next year. Else, price it yourselves.

3.  Any opinion on founders getting some (but low) liquidity at time of funding?

There has been a trend lately with late stage deals, for the founders to take money off the table during funding. These companies are usually cash flow positive and the only way for the VC’s to get enough money to work in the deal is to buy founders’ shares. Couple of things to note:

1) this stock is usually common and the new money coming in is preferred. If preferred is priced at $1.00, then common will be priced at a discount to this (often 20-50%) depending on the size of the preference stack (preferred money in). The more preference in, the greater the discount. Founders are often shocked by this discounting. Also, remember to keep this pricing of common consistent with how you are pricing your options. This common sale is a third party pricing of the common. You have to issue your options at that price as well.

2) VC’s generally don’t like to see founders take money off the table. Historically, it has led to founders losing drive and some motivation if they already have their nest egg and the rest is "house" money. Some founders remain equally motivated, but it is hard.

4.  Is there such a thing as "deferred compensation" for the founders — and a way to recoup some of This at time of funding?

Founders equity is supposed to account for this. It is truly deferred comp in that you don’t get it until the company is sold and shares are liquidated. Some founding teams will put an IOU in place for a couple of themselves (like an accounts payable). However, new investors are keen on this. We want new money to go towards future growth, not to paying back wages. Also, we would like to see founders acting consistent with an equity culture versus a cash/current comp culture. When founders think and act like shareholders, their interests are much more aligned with the VC’s. Unless there are specific, unique family issues (three kids, etc), taking money off the table for past salary usually doesn’t play well with new investors.

I was talking with a friend of mine, Patrick Dealy, who is at MaxMD about the pro’s and con’s of taking strategic money. MaxMD has an interesting business model, based upon their being the primary registrar for the .MD domain extension. Doctors and medical institutions can register for www.drname.md there while also beginning to sell a variety of ancillary offerings (HIPPA-compliant email, etc). It becomes a nice Trojan horse for them to penetrate the medical industry.

During the bubble, companies and VC’s actively sought out strategic investors for the "C" and "D" series of financings. They relied on the "irrational exuberance" along with strategics’s limited VC experience to get them to overpay (often 2x and 3x what a comparable VC would have priced the round at). Like any system based on poor, unsustainable fundamentals, this did not end well for the strategics and most shut down their venture arms. Those that stayed involved like Motorola & Intel, remained disciplined and are more active than ever, often getting invited in the first or second round.

While strategics are starting to come back into the market, we are not seeing the silly valuations of the past, though, because of the extra strategic value, they may pay a modest premium. More importantly, they are better educated and bring more to the table, often, than money.

Should you take strategic money? Negatives are: a) if they are a customer/partner, the investment may deter other customers from working with you, b) if they are a potential acquirer, it hinders your sale at the end since others will wonder why an insider did not buy the company first and c) strategics rarely invest across multiple rounds so not a good source if you are looking for investors with rainy day dry powder.

In reality, I have not seen (a) become an issue. In fact, I am seeing strategics (even competitors) coming in together on rounds. Since they are minority investors and often passive, this has not usually spooked other potential partners. This is not to say that it never happens, so evaluate your own situation. Every once in a while, (b) does become an issue. So, it is usually best to not take money from a potential strategic acquirer unless it is clear that they are the primary/sole acquirer.

The benefits are: a) you can often get a boost in credibility if a major strategic in your space takes an interest. If you are a wireless play and Motorola puts money into you, it signals to others that their tech groups canvassed the market and you had the best technology and b) they can often bring strategic benefits to you…access to their tech teams or channels, promotion to their customers, market insight, etc. Being fellow Chicago VC mafia members, we actively look for ways to work with Motorola Ventures.

So, I am generally supportive of strategic investors coming in assuming you have minimized the potential negatives of the deal. Make certain that the money brings with it enhanced value beyond the dollars. Talk with the relevant business units before closing to layout, if you can, a game plan for post investment.

"The most important contribution of management in the 20th century was the 50-fold increase in the productivity of the manual worker."
                                            -Peter Drucker

Drucker followed the previous quote by stating that the most important challenge of the 21st century would be driving similar productivity gain from the knowledge worker. I have had plenty of time to ponder this topic as I have suffered through a strong head cold at home. I have found myself increasingly enslaved to the information Samba. I go from my email to my voice mail to my in-box to RSS reader. By the time I have done one round of the dance, everything has filled up again. Furthermore, like quicksand, the more rapidly I move through this routine, the quicker they fill up from responses. Lord forbid that I have core projects to take care off outside of this dance. After too many 1 and 2am mornings, my body finally put the brakes on with the help of Acute nasopharyngitis (the common cold).

Between prolonged naps and chicken soup, I have pondered how this could be the basis of a post. Thoughts ranged from viral analogies (marketing, etc) to biology. In the end, the takeaway was the simplest of them all. The demands on entrepreneurs (and VC’s) are never ending and unless systematically managed, they spread, like a weed, and take over every waking hour (and even quite a few previously nocturnal ones as well).

One brain study used PET Scans to analyze brain activity in high IQ people. Rather than showing increased activity across the brain, it actually showed focused activity around the core topic. In other words, mental superstars did well not because they could process more (though many can) but rather that they isolate out the noise and focus only on what is essential.

The Economist recently published an article "Reprogram Your Life" that was the genesis of this post. The challenges and distractions we experience today take a very different form from those even 15 years ago…email being the most obvious. The article talks about "life hacking", tricks or "hacks" to reprogram your life. It mentions ideas like setting your email client to pull down email less frequently (say every 30 min) or having "vertical days" where you turn off all distractions (cell, phone, email, etc) and focus on a core task. It mentions two sites, www.43folders.com and www.lifehacker.com which have frequent posts on suggestions.

We fill our lives with urgent activities without fully thinking through what is important. These are Stephen Covey issues on steroids. I posted earlier about how critical balancing family and work lives…well, this is the battle ground.

Some suggestions:
— lay out your goals and core principals at the beginning of each year. these become the northern star against which you can prioritize. redress/modify from time to time.
— prioritize what you need to get done on a daily basis
— weave emails into your prioritized tasks versus responding to "action" emails immediately
— at the end of each day, look at what you did, what was of value, what was not and change future scheduling and time allocation. This works best around chronic time wasting activities
— if you have an assistant, have him/her prune your email for you, handling all scheduling activities
— when you find life spinning out of control, take some time off for Mindfulness (take a walk, clear your mind, meditate, etc). It will help put things into perspective and priority.
— if you procrastinate around major to dos, take 10-15 minutes to break them down into actionable sub items and weave them into your tasks
— militantly say "no" to task forces, committees or meetings that are not core or essential
— there are hundreds of books, blogs and articles around this stuff. Find an approach or set of strategies that work for you.

As with the PET Scan study, it really is about learning what not to do rather than doing things more efficiently. If you want to play in this world, you had better learn to "hack" or be prepared to spend many hours in bed with tissues and cold remedies…

People often ask us what we look for in a company and entrepreneur before we will invest. The short list is:

1) company is or has the potential to be #1 or #2 in its space either nationally or globally.

2) either the CEO or CTO is well known, connected and respected in his/her industry (and experienced), is ethical and is someone we want to build a business with.

3) the business model is compelling and clearly scales. By compelling, I mean that we are happy with each dollar that comes in.  We want to avoid the story: I am losing money on each unit, but I will make up for it with volume. By scalable, I mean that we can see the mechanism or approach by which the company can ramp to be a sizable business.

4) the company is rationally priced

It is a rare situation when we come across a company that is a leader in its space, is doing nine figures in gross revenue and has never taken outside capital. It is even more rare that such a company, given its size, is growing 70-100% a year.  TicketsNow, located in Crystal Lake, IL, enjoys all of these and I am pleased to say that it is the latest addition to our portfolio.

Started on $100 by Mike Domek from his dorm room, TNow is the highest trafficked site worldwide in the premium ticket world. We could not be more excited about backing Mike and his team which includes Kenneth Dotson (formerly CMO uBid and co-founder CBS Sportsline), Mike Stein & Mark Hodes (formerly ran CRM and online marketing at Orbitz), Frank Giannantonio (former Land’s End CTO) and Sridhar Murthy (former CFO or VP/Finance at Ariba, Collabnet & Get2Chip).

All readers are encouraged to get their next premium sporting, show or concert ticket at www.ticketsnow.com!

Balancing work and family is one of the greatest challenges for an entrepreneur. Left unchecked, your business can consume every waking hour. There are always sudden firedrills, new customer pitches or urgent personnel matters. How do you balance everything?

I will be introducing a future feature called "Behind the Firewall". It will be a series of guest blogs from leading entrepreneurs and this will be the first topic.

While their perspective will be the more relevant, I have three comments on this topic:

1) Sanctuary: your family and friends are your greatest resource. They are your sanctuary from the often random corporate world. Keep your spouse in the loop and take care of the relationship. Also, it is key to make time for your kids.  I wrote about how important this is in my post "Resilience in the Storm". This is the only thing you can count on when things gets rocky on the business front.

2) Team: build out a team that you can delegate to and trust. If you find yourself jumping deep into functional areas, you either a) need to learn to delegate better or b) have the wrong lieutinents. This is not to say there won’t be times when you need to get more involved, but too often we see entrepreneurs try to do too much of it themselves. This is the leading area that indicates whether an entrepreneur can scale with his/her business.

3) Funding: determine if you want your business to be a lifestyle business or a swing for the fence before you take capital. Also, assess which your business is best suited for.  Fund it accordingly. Venture capital demands rapid growth. Once you have taken VC money, expectations rise and so will the demands on your time.

More to come on this topic from those in the trenches…