The Power of Dry Powder

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.

What Sequoia Expects from Entrepreneurs

Entrepreneurs are always trying to figure out what it takes to get funded by the brand name venture groups. VCRatings recently wrote a post using Sequoia’s website criteria for what they look for in a start-up. While these seem fairly straight forward, I thought it would be helpful to expand on some points. Historically, the elements that are the hardest and most intangible are:

1) Team DNA: this is one of those "you’ll know it when you see it". However, if the VC knows more about your space or business model than you or you come across as naive due to your claims, it is not a good start. The tech world grows more Darwinistic each day and those with the best street smarts win (not always the brightest). "A’s" attract "A’s".  Compare your team (honestly) and yourself to your highest profile competitors and determine how you stack up along the lines of creativity, tenacity, execution, public persona and such. Also, do the same against the "best in class".

2) Think Differently: VC’s get lots of pitches on any given area. It is those teams that can think about a problem or solution from a different angle, especially one that makes it more defendable, that stand out. It makes a VC want to hear more about how the team views the problem. Teams that can approach a problem from a different angle are advantaged since other competitors will be biased towards their own way of thinking (which may be flawed or too traditional/cookie cutter). This gives the team a head start and on-going advantage if they have the better mousetrap regarding approach.

3) Agility and Frugality: Iterate quickly and see what the customer wants. Keep it simple. While you’re at it, don’t spend a lot. Money doesn’t solve problems but usually causes defocus. Mike Cassidy (of Direct Hit and Xfire fame) believes in keeping everything to a minimum when launching to force focus and discipline. Think small and fast.


VC Return Myth

I often see in the press that a company was acquired for $x million (say $200m) after having taken $y million in investment (say $20m). They often then go on to say that this led to a 10x return on investment.  This is wrong unfortunately (for us VC’s). The final return depends on what valuation the money came in at. If the VC’s owned all the business, then it is 10x. However, if they came in at a $280m valuation, they made 1x their money if it was preferred stock and about 1.6x if it was participating preferred. On several occasions, I have seen articles written about exits in our network where I know that investors made 3x their money. The articles put the return at a significantly higher level.

An example of this is the YouTube acquisition. Some speculate that the initial $3.5m in Sequoia money went in at a  $15M valuation which would give them roughly a 20% stake and that the second $8m tranche went in closer to $200m in value. I don’t know the right numbers, but if this is correct, then Sequoia would end up with about 23% of the company when the dust settled or about a $380m payout. This would result in a 33x return on their money. Not bad for a year and half’s work. That said, I have also seen some articles or posts talking about 100+x money.

Many reporters dig deeper to get to the real numbers. However, when you see an article about a big exit, don’t always assume that it resulted in a big win for the investors. We have been known to over-price our deals on occasion (more so these days) and this obviously impacts the return multiple.


One advantage of being in the Midwest is you get a very clear view of where we are in a venture cycle.  This region is usually the last to get liquidity and one of the first to lose it. It is kind of a proverbial high water mark on the sea shore. Our angel investors, often family offices or successful manuf/services executives (versus the sea of former tech CEO’s in CA), tend to be more conservative in their investing. And, coastal venture firms do not like the 3-4 hour flights (plus driving to smaller cities) to get out here. They will generally only start to come out here once they have fully fished out the watering holes on the coasts and surrounding territories. When both are in full force, the venture business eventually gets cracked like a nut from both sides.

When the market is at a low, you can’t get angels here to take out their wallets even at gun point. However, when the financial cycle has run long enough, and all asset classes seem safe (and traditional ones boring), they get very aggressive. When you begin to see angel rounds approaching $5-10m, you know that we are nearing a top.

During this cycle, the angels are having even more impact than before. Since technology is so relatively inexpensive, many of these companies do not require, if managed properly, considerable capital. So, angels with $3-5M can very well disintermediate early stage VC’s. Should the business plans work out as expected, this sometimes could be all the company needs. However, should the company require more capital (more often the case), especially during a market downturn, then the VC’s will get another bite at the apple and the angels will suffer from having paid up too high in the first round. In the meanwhile, the company has gone without the various benefits associated with having venture investors and their connections.

This should be great news for later stage VC’s since they should be seeing a wider array of proven companies. However, the allure of significant management fees have draw fund after fund into raising too much capital again ($500m+) like the sirens on the crashing rocks. So, valuations are shooting up through the roof as VC’s compete with each other. They are also jacking up prices so as to convince entrepreneurs to take on more capital (dilution mitigation).  We have recently returned back to 2000 level pricing. As VentureOne reports for the last quarter:

"According to industry tracker VentureOne, the median pre-money
valuation for venture-backed companies in the U.S. was $20 million for
the half, compared with $15 million for all of 2005. The last time the
median figure reached over $20 million for the year was in 2000, when
it hit a lofty $29 million."

Meanwhile, GP salaries have hit an all-time high in the venture business…senior partners are pulling in, on average, over $1.5M annually before carry. (not here, so I need to look into things 🙂 ). The management fees keep the dance going and inflating. On the other hand, IPO’s remain moribund. More start-ups, higher valuations, more capital into each…where have I seen this before?

Once the market turns, this will all wash out, angels will go back to S&P and T-Bills and LP’s will go back to GP bashing as these uber funds under perform. However, the venture business is stuck in this two way nutcracker in the meanwhile. Chestnuts anyone?

Where Does Power Lie

"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.

The Math of Dilution

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

"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…

Venture 101: Where Do VC Firms Go to Die?

“The Dead Body That Claims It Isn’t: I’m not dead.
The Dead Collector: ‘Ere, he says he’s not dead.
Large Man with Dead Body: Yes he is.
The Dead Body That Claims It Isn’t: I’m not.
The Dead Collector: He isn’t.
Large Man with Dead Body: Well, he will be soon, he’s very ill. “
— Monty Python and the Holy Grail

Where do VC firms go to die? What does this passing look like (and can entrepreneurs pay to watch)? You are seeing quite a few firms going out of business, including a number of prominent ones like Worldview and now Crescendo. In the PE Week Article: Crescendo Ventures…To Raise or Not to Raise, the article lays out why it takes so long for firms to go under. Worth a read to see the inner workings of the VC world.

Venture funds are 10 year vehicles normally with a couple of one year extensions. The GP’s can invest, normally, for the first 6 years and then harvest after that. It is not until the 6th year, usually, that the management fees begin to decline (go from being based on the committed capital to being based on remaining cost basis of the portfolio). Firms generally try to get their next fund up and running with a new set of management fees before the old fund’s fees start to decline.

However, in an environment such as this one, many groups deep sixed their 1999-2000 funds, and have not had enough realizations on their 2001-4 funds to get LP’s excited about supporting their next effort. The IPO market has languished for years and it is taking longer to ramp businesses up to acceptable revenue levels for exit. Plus, with some sector overfunding, there is an oversupply of acquisition candidates in many spaces (buyers’ market). So, the 1999 and 2000 era funds are seeing managment fees drop. Many groups are looking at cutting overhead (staff) to make due while also seeing if their portfolios are salvageable. Some, like might be the case with Crescendo, decide not to raise another fund (can’t salvage the last two funds) and the partners go their separate ways.

All Good Dogs Go to Heaven…not certain what the case is for VC’s…

Venture 101: Plasma Inflection Point

"In times of rapid change, experience could be your worst enemy."
— J. Paul Getty

As we have written, VC’s are creatures of habit. Pattern recognition is our primary weapon of the trade. What makes the difference between a good VC and a great VC is how effective he/she is at making profitable decisions during periods of inflection and when old rules/experiences may hinder rather than help. In yet another example of how quickly things change when they go, look at the TV set world. The NYT has a great article "Picture Tubes Are Fading Into the Past". It just seems like a couple of years ago that flat panels were starting to reach "affluent" affordability and just in the last 18 months when more and more friends were bringing them into their houses. Now, major manufacturers are getting out of the CRT world altogether (Panasonic) or almost out (Sony). You want to be "where the puck is going, not where it is" in these cases.

You can see this starting to hit other areas as well like IPTV use/adoption. Never a dull moment in the venture world.