So you see a pattern here?

Number of VC-backed IPO's:
1995    205
1996    272
1997    138
1998      68
1999    250
2000    202
2001      22
2002      20
2003      23
2004      67
2005      43
2006      56
2007      76
2008        7 (none in Q2 or Q4!)

Average Time to IPO
1998    3 years
2008    9 years

Number of Companies Funded:
1998    1,896 ($14.0B invested)
2008    1,930 ($14.1B invested)

When you cut through all of this data, what you see is that VC's portfolios have filled up with deals while there has been little liquidity.  With 1,930 companies funded but only 7 IPO's (and another 300 M&A's), you have a lot of overhang in the existing company portfolios. The average time to exit has grown linearly since 2000. For entrepreneurs, what this means is exits will take longer to realize, requiring a long-term perspective to decision making and strategy.  Also, VC's are going to be very pre-occupied managing existing companies and have less time to a) due new deals and b) spend time with those deals.

The IPO machine will not likely return until the markets have hit bottom, stabilized and begun their growth again. Additionally, the notion of a promising $30m in revenue company (like Apple was) going public has been replaced by $100m thresholds. This means M&A is the primary driver of exits for some time ahead, which requires less swinging for the fences and more low burn/capital raised.

Interesting stats…

As these markets continue their chaotic path downward, people's true colors come out. Some people show increasing amounts of fairness and consideration. Others will self-optimize and use every bit of leverage that they can get their hands on.

Two entrepreneur friends of mine recently had a very negative experience with an investor who has a reputation for being Machiavellian and it really, really has incensed me.  These slimy bottom suckers use the changing market conditions to test how low they can retrade an existing deal.  Here is the standard game plan for these kinds of assholes. When they sense a dramatic change in the market, they pull away their term sheet siting "policy" changes. However, instead of walking away from the deal, they mention in passing that they might reconsider under "different terms". If the entrepreneur bites, they know that they have leverage and they proceed to throw down absolutely egregious terms (multiple liquidation preference, half the original price, etc). If the entrepreneur bites on this, they know they really have them and continue to ratchet down the terms until things break and they back off.

Entrepreneurs who have a retrade occur, must first figure out how badly they need the money. If they can get the runway from expense cuts or manage to breakeven, then they should tell the investor to pound sand as soon as they mention "different terms". Remember, even if you get this round done, you will be stuck with this scum for years to come and any time things go the wrong way, they will use their leverage to take another pound of flesh. This falls into my category of "Life is too short to deal with Assholes". If you have to take the money, negotiate as hard as you can, realizing that they will continue the downward ratchet. Try to drag out discussions and aggressively start talking to any other possible sources, even if under the same terms (if you think they are decent people, at least the match won't burn twice).

Before dealing with someone, especially an investor, find out what their reputation is in ugly situations. Did they roll up their sleeves and help the CEO or did they use the situation for leverage to self-optimize. Animals don't change stripes so assume you will see more of the same with yourself.

If I wasn't concerned about libel issues, I would list a couple of these known predators (with details) such as the one pimping my friends. I can only hope that the Laws of Karma eventually return the favor…

"Thus far in the second quarter of this year, there have
been NO venture-backed IPOs.  There has never been a quarter where this
situation has occurred (since NVCA has been tracking such data). "
  — NVCA Mailing

I am pronouncing this cycle official dead at Q2, 2008. We have a general VC cycle that lasts 7-8 years and whose downturn generally lags the public markets by 6-9 months. With the credit crunch hitting in Q3 of 2007, I was expecting things to turn sharply in our business in Q1-Q2 of 2008. Just in the past month, term sheets seem to be disappearing and valuation dropping rapidly as firms begin to dig in. Groups that have been Lone Wolves for the past couple of years are suddenly looking to syndicate. Yes, things are about to get ugly for the next 2-3 years so brace yourself.

If you are close on terms with an investor, do what you need to get it closed now. If you have access to capital, draw it down and don’t touch it as it may need to last a while. If you have a high burn rate, you had best start aggressively cutting it now. If you are going into this cycle burning $1m/mo, you will have no ownership left by the time the cycle turns up and if you are burning more than $500k/mo, your cap structure is going to take a hit if things turn out as badly as I fear. In these kinds of times, breakeven is great (wait out the competition) and $100-200k/mo burn is manageable.

Ad rates are starting to fall so expect the carnage to start piling up in the coming year in the "ad-based model" world. The cycle is coming around and I don’t think rate cuts are going to holds things off much longer. I hope that I am being Peter (and the Wolf) and not Cassandra here!

Patient has flatlined Q2…

A number of entrepreneurs have asked me recently about how VC’s view founders taking money off the table these days as part of a financing. Until the past 5-10 years, this was a non-starter for most VC’s. VC’s want to have strong alignment of interest and complete commitment to a deal if they are going to place their capital in. VC’s often use the “Cortes burning his ships (1519 at Veracruz)” analogy. If the entrepreneur has taken money out, he/she has one foot partly out the door and should things not go well, he/she has a cushioned exit. One could also argue that he/she is not as hungry or driven. It also emphasizes more the “making money” over the “changing the world” aspects of starting a business.

However, as VC’s raised larger and larger funds, they began to have trouble getting large enough chunks to work as new capital (too much dilution). So, they began to encourage entrepreneurs to take money off the table as a way to get $5m, $10m or even $50m more into a deal. As word got out, more and more entrepreneurs began to push for this ranging from a couple hundred thousand to several million.

The counter to the Cortes point is that having too much “on the line” (especially when family is involved) does not lead to healthy decision making either. Too much stress and fear of loss will result in some irrational moves.

So, while I am not a big fan of entrepreneurs taking money off of the table, one could argue that perhaps letting entrepreneurs take a bit off the table is healthy as long as it ends up providing more of a safety cushion for family versus a change in lifestyle. That said, it still begs the question: if the deal is so attractive and a must for a VC, why is the entrepreneur giving up 10x on that equity sold (or is he/she)?

Yesterday on the the VC fundraising panel at the TECH cocktail conference, Eric asked the VC’s how an entrepreneur can hook up with a VC. (BTW, great job Eric & Frank pulling off a class A event). While there is the standard answer of “networking and finding people who know the VC for a qualified intro”, I believe there is another more important suggestion that is often missing. Entrepreneurs are very targeted when they determine who to sell their product to (right fit, receptive, budget there, etc). They should do the same with fundraising. In other words, you should be very specific with who you want to raise from and why. Specifically, you should identify those VC’s (not firms, but individual VC’s at the firms) who have been a) active in the space and b) who are well known in the ecosystem. In sectors where there are only one or two, then you obviously need to expand beyond. Even if they don’t fund your business, you will usually get great feedback on the competitive landscape, informed analysis of your business model and potentially other connections (VC or business) to talk with. So, look for the prominent plays in your general space (not competitors as you don’t want your info possibly getting out) and find out either a) who backed them or b) who they think are the players in the space. Network in as per above and go from there.

I am talking tonight (Thurs, Dec 6th) at the Ignite Chicago event (click for the site) at the Debonair Social Club (1575 N Milwaukee Ave). I was originally going to do a talk on Venture vs Angel fundraising. However, I have decided to change topics last minute and do it on Nassim Taleb’s book, The Black Swan: The Impact of the Highly Improbable. I have written in the past on this topic, The Turtles of Omaha, but was inspired to do another post (coming) and change the presentation after Steve Jurvetson gave a compelling talk on our monthly partners call this morning on the book & topic. For those interested, you can download the original presentation on fundraising, Off to See the Wizard, by clicking. Download 2007_12ignite_talk.ppt.

Wikipedia gives a brief overview in its Black Swan Theory entry.

Jason and Brad at AsktheVC forwarded to me a question sent in by one of their readers. Their site is a great site for answering a broad array of questions regarding VC and entrepreneurship.

Question: What’s a completely generic range of equity a VC typically wants for a round 1 or round 2 investment?

Most VC’s will generally say they target 20-30% ownership in a company to “make it worth their time”. This means that if they invest $3m early on, they expect the post-money to be around $10-15m and if, in later rounds, they are investing $10m, they expect to have a $30-$50m post-$.

Often, however, VC’s will use the “percentage” threshold as a means by which to increase money into a round or to get the valuation down. I have seen a given VC say they need 25% ownership for deal (to get valuation down) and do a more competitively sought deal at 15% two weeks later. In the end, two things drive all of this. First, there are legitimate minimum investment amounts a firm needs to have per deal. A $500 million fund will never get its capital deployed by doing $2m and $3m deals. They need to put $7-10m to play early and $20m+ over the life of the investment. Second, the valuation (and hence % ownership) will be driven by attractiveness and competitiveness of the deal. In the end, it is really about valuation (assuming their investment appetite remains in a set range).   

Nearly all VC’s use convertible preferred stock as their vehicle of choice. Most entrepreneurs know this but many don’t fully understand the different flavors and elements of it.

Preference refers generally to the seniority of a given class of stock versus others. Preferred A stock usually gets paid back before common and follow-on Preferred issuances (B, C, D, etc) usually have seniority over both the A and common. This means that the investors will get their capital out before the entrepreneur and team usually.

There are two primary forms of Preferred stock: straight and participating. Straight convertible preferred stock is an either/or situation. Investors can opt to get their capital back but not participate in further upside (e.g. stay as preferred stock…usually the election in downside scenarios) or they can convert to common and participate alongside management & the entrepreneur. The kick point of this conversion is usually pretty clear. If an investor has put $10m in and has 10% of the company, for any exit that values equity above $100m, they will convert to common. For any exit below, they will stay as preferred.

With participating preferred, investors first get their initial capital out and then participate as common shareholders. So, in the above case, at $100m, the investor would get his/her $10m back and then would get an additional $9m (10% of the remaining $90m). Investors will often use this to hit return targets when having to pay a high initial price.

Some term sheets will include participation multiples where investors get 2x or 3x their capital out before other classes. This usually happens when there is significant preference (invested dollars) in the company and there is gap between when their get their capital back and when they start to participate in the upside.

Dividends also play a role in preference. There are cumulative dividends and “when & as declared by the board” dividends. With cumulative dividends, investors “preference” grows each year at a set rate (say 6%), thereby providing an ongoing discount for the investor. This dividend begins to kick in day one. Other dividends start only “when & as declared by the board”. I have not generally seen many boards vote to trigger a dividend.

New preferred stock can be either senior to previous preferred classes (say the Pref B gets its money before the Pref A) or it can be “pari passu” to them (the Pref B and Pref A have the same seniority and come out pro-rata based on their relative sizes). This term usually does not affect the entrepreneur who is subordinated to both classes but is an investor group matter.

As market conditions tighten, investors look to offset increasingly rockier environments through more aggressive terms. As they get more competitive, terms trend more loosely. Lastly, while earlier investors may lock in strong terms, everything is up for renegotiation when new investors come in. Previous preferred terms can stay in place or, in severe cases, get pushed to common. Participation multiples can be eliminated as can dividends. However, for entrepreneurs looking to use new financings to recut their deals, they should be careful. Earlier investors usually have blocking rights on new capital coming in. Additionally, entrepreneurs that play the sides against the middle (old vs. new investors) will significantly impair their relationship with initial investors if they blatantly play this card.

Preference takes many forms in venture capital. It is critical that entrepreneurs fully understand the implications of the terms they are accepting so that it does not impact future relationships going forward.

Nearly all VC’s use convertible preferred stock as their vehicle of choice. Most entrepreneurs know this but many don’t fully understand the different flavors and elements of it.

Preference refers generally to the seniority of a given class of stock versus others. Preferred A stock usually gets paid back before common and follow-on Preferred issuances (B, C, D, etc) usually have seniority over both the A and common. This means that the investors will get their capital out before the entrepreneur and team usually.

There are two primary forms of Preferred stock: straight and participating. Straight convertible preferred stock is an either/or situation. Investors can opt to get their capital back but not participate in further upside (e.g. stay as preferred stock…usually the election in downside scenarios) or they can convert to common and participate alongside management & the entrepreneur. The kick point of this conversion is usually pretty clear. If an investor has put $10m in and has 10% of the company, for any exit that values equity above $100m, they will convert to common. For any exit below, they will stay as preferred.

With participating preferred, investors first get their initial capital out and then participate as common shareholders. So, in the above case, at $100m, the investor would get his/her $10m back and then would get an additional $9m (10% of the remaining $90m). Investors will often use this to hit return targets when having to pay a high initial price.

Some term sheets will include participation multiples where investors get 2x or 3x their capital out before other classes. This usually happens when there is significant preference (invested dollars) in the company and there is gap between when their get their capital back and when they start to participate in the upside.

Dividends also play a role in preference. There are cumulative dividends and “when & as declared by the board” dividends. With cumulative dividends, investors “preference” grows each year at a set rate (say 6%), thereby providing an ongoing discount for the investor. This dividend begins to kick in day one. Other dividends start only “when & as declared by the board”. I have not generally seen many boards vote to trigger a dividend.

New preferred stock can be either senior to previous preferred classes (say the Pref B gets its money before the Pref A) or it can be “pari passu” to them (the Pref B and Pref A have the same seniority and come out pro-rata based on their relative sizes). This term usually does not affect the entrepreneur who is subordinated to both classes but is an investor group matter.

As market conditions tighten, investors look to offset increasingly rockier environments through more aggressive terms. As they get more competitive, terms trend more loosely. Lastly, while earlier investors may lock in strong terms, everything is up for renegotiation when new investors come in. Previous preferred terms can stay in place or, in severe cases, get pushed to common. Participation multiples can be eliminated as can dividends. However, for entrepreneurs looking to use new financings to recut their deals, they should be careful. Earlier investors usually have blocking rights on new capital coming in. Additionally, entrepreneurs that play the sides against the middle (old vs. new investors) will significantly impair their relationship with initial investors if they blatantly play this card.

Preference takes many forms in venture capital. It is critical that entrepreneurs fully understand the implications of the terms they are accepting so that it does not impact future relationships going forward.

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.