(Don’t) Go West Young Entrepreneur

After launching my career in and around the high impact entrepreneurship space and venture capital in Silicon Valley in 1985, I moved on to North Carolina in 1990. After an .. exhilarating? … run as a venture capital investor (fund class of 1999 which, if you know the history of the business, is more than enough said) I proved to myself, at least, that sometimes you can just go home. In my case, home was Neenah, Wisconsin.

My career is still all about high impact entrepreneurship and investing: my experiences over the last ten years demonstrate that high impact entrepreneurship is doable in Wisconsin. More than that, it has, I think, a bright future. But … and this is where I tend to get into trouble … let’s not kid ourselves. Wisconsin’s high impact entrepreneurs, circa 2014 and for some indeterminate time to come, as a rule (there are exceptions, but mostly of a kind that prove the rule) face more and more daunting challenges than their peers in Silicon Valley. Or even New York or Austin, for that matter; but let’s be straight about it. Silicon Valley is the gold standard for high impact entrepreneur environments.

Last week, at the Wisconsin Entrepreneurs’ Conference, I was on a panel talking about common mistakes entrepreneurs make. And I said something, publicly, that I have said privately before. To wit that if a high impact entrepreneur’s only objective is to raise the most venture capital, as fast as possible, at the highest price, that entrepreneur should move to Silicon Valley.

Being that the setting was, as mentioned, the Wisconsin Entrepreneurs’ Conference (and kudos to the Wisconsin Technology Council for another great event), my declaration was not particularly embraced by the crowd. But it is what it is. Silicon Valley is to the high risk entrepreneurship and investing world what Rome was to the Roman Empire. It is where pretty much all of the significant roads lead. It is where about one half of all the venture capital in the country is invested (that would be two orders of magnitude more venture capital than has historically been invested in Wisconsin). The Silicon Valley entrepreneur/venture capital eco-system is by far the broadest and deepest in the world. That is not a boast, that is just a fact.

But if Silicon Valley is the center of the technology-driven entrepreneurship and investing universe it is no more the only place in that universe than Rome was the only place that mattered in the days of the Empire. Entrepreneurs can and do build great companies in places like Wisconsin. They do it because raising the most money at the best price as fast as possible is not their only objective. They do it because while it might be easier to build a startup bigger, better and faster in Silicon Valley, they want to do it somewhere else – like Wisconsin. And, frankly, I applaud them for it. Selfishly, if there were not entrepreneurs and risk capital investors who wanted to do their thing in Wisconsin even if it might be harder to do here than there, well, I would not have anything, career-wise, to do here. And I like it here, too.

So if you are one of “us,” that is one of those folks in the high impact entrepreneurship and investing space that calls Wisconsin home, three cheers. But do it with your eyes open. You can get financed in Wisconsin. You can build winning high growth/risk teams in Wisconsin. You can find savvy startup lawyers, accountants, advisers, mentors and partners in Wisconsin. But it will likely take a little more time and effort than it would in Silicon Valley. And you will most likely have to compromise a bit more on your financing, growth and exit expectations. Good for you. You gotta love our winters.

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Partially Participating Preferred: An Alternative to Participation Caps

In an earlier blog (Capping Preferred Participation: A Compromised Compromise) I argued that the usual middle ground between entrepreneur-friendly “non-participating” preferred stock and investor-friendly “participating” preferred stock – capping participation at some multiple of an investor’s base preference – is seriously flawed.  Herewith an alternative approach.

By way of a quick refresh, we are talking about “participation” in the context of a preferred stock liquidation preference.  In an exit transaction (other than an IPO) an investor holding “participating” preferred shares gets two bites at the exit proceeds apple.  First, a bite equal to his base preference (typically an amount equal to his investment) and then a second bite equal to his pro-rata share of the remaining exit proceeds.

An example.  An investor who put down $1 million for a 40% ownership position in Newco in the form of “participating” preferred shares would, in the event Newco was sold for $3 million, receive $1 million “off the top” and in addition 40% of the remaining $2 million of proceeds, for a total of $1.8 million.  That means the investor, who owned 40% of Newco when it was sold, would get 60% of the exit proceeds.  If, instead, the investor held “non-participating” preferred shares he would, in this example, receive either (at his option) (i) his $1 million base preference or (ii) his 40% pro-rata share of the $3 million, or $1.2 million.  Clearly, the investor would take the $1.2 million pro-rata share.  And leave the entrepreneur with $400,000 more money than he would have had if the investor had held participating preferred.

Looking at the above example, it is not hard to see why entrepreneurs don’t like participation and investors do: while the relative impact of the participation right diminishes as the exit proceeds rise (in the example, the difference is always $400,000), at every exit that leaves anything for the common shares, the investor with participating preferred gets more and the entrepreneur less.

In light of the above, entrepreneurs and investors long ago came up with a compromise on the participating/non-participating issue, the so-called “participation cap.”  As with non-participating preferred, “capped” participating preferred gives an investor a choice.  When exit proceeds are being distributed, the investor can choose to take either his pro-rata share of the proceeds (his percentage ownership at the exit) or his base preference plus participation in the distribution of the remaining proceeds until he has received in the aggregate an amount up to some multiple – say 2x, or 3x, etc. – of his base preference.

Now at first glance, capped participation seems like a reasonable compromise on the participation/non-participation negotiation.  As my earlier blog pointed out, however, it is a compromised compromise.  The problem – if you don’t want to go back and review the prior blog, just trust me on this – is that when you cap the participation preference you create a situation where there is range of exit proceeds (a “zone of indifference”) where an investor doesn’t care what the exit proceeds are.  In the example in the earlier blog the investor got the same payout ($4.5 million) for exit proceeds anywhere between $6 million and $9 million.  Faced with a deal that promised $6 million in exit proceeds, the investor would have no incentive to negotiate for a higher price unless he thought he could get the price up at least to $9 million plus one dollar – in which case the investor would get a fraction of that final dollar.  A savvy entrepreneur should, it seems to me, be skeptical of an arrangement where an investor was indifferent over how much money the company was sold for over a significant range of plausible exit scenarios.

Fortunately, there is a better compromise, to wit “partial participation.”  In this compromise, the entrepreneur and investor agree that the investor’s “second bite” at the proceeds apple will be some fraction of the investor’s pro-rata ownership share.  So, for example, that fraction might be one-half.  Going back to our initial example where the investor has invested $1.0 million for a 40% ownership interest, and the exit proceeds amounted to $3 million, the investor would first get his base preference ($1 million) and then get an additional $400,000 (one-half of 40% of the remaining proceeds).  The “second bite” would be worth exactly one-half of what it would be worth if the investor had full participation.  If the partial participation fraction was set at one-quarter, the “second bite” would be worth exactly one-quarter what it would be worth compared to full participation, and so on.

Compared to capped participation, partial participation is much easier to understand – the compromise consists of picking a fraction between 0 and 1, which such fraction perfectly represents the way the compromise plays out as a fraction of full participation.  But even more important, partial participation has another big advantage over capped participation: there is no zone of indifference.  There is no range of exit prices where the investor is anything less than fully incented to work with the entrepreneur to negotiate a better price.  And that, for me, makes partial participation a better participation compromise.

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Choosing Counsel for your Startup

Ok, being a lawyer in the high impact entrepreneur space myself, writing this blog (well, posting it) is a bit awkward. But having seen – not only as a lawyer but also as a serial venture-backed entrepreneur myself, as well as venture capital and angel investor – so many entrepreneurs squander so much money, energy and time working with the wrong lawyers (and more than a few deals crater as a result), well, it just has to be done. So here goes: my advice to high impact entrepreneurs on picking a lawyer.

Rule number one: pick a lawyer who spends at least a majority of her time working with high impact entrepreneurs and investors. These folks may not be any better at what they do than lawyers who spend their time in other areas – say, for example representing traditional small businesses or large businesses. But just as, when you have a problem with your knee, you look for an orthopedic specialist (and maybe even a knee specialist) rather than a cardiologist, so when looking for a lawyer for your startup you should look for a lawyer who specializes in that market niche.

If you need some convincing on this, here are some of the things that distinguish counseling high impact entrepreneurs from counseling other business clients.

1. Startup lawyers should be comfortable and effective regularly working directly with entrepreneurs and their business and technology teams as well as their investors. That’s something that most lawyers who spend their time with bigger, more established business clients don’t generally have to do.
2. High impact entrepreneurs and their startups have much higher risk/reward profiles than their small and big business counterparts. As a result, they are best served by lawyers who are comfortable and effective providing legal support for business strategies and tactics that lawyers accustomed to representing traditional small and larger businesses would find, well, too risky. Put differently, while lawyers for traditional small and larger businesses tend to look for reasons to say “no” to their clients, lawyers for high impact startups tend to look for ways to say “yes.”
3. Angel and venture capital financing, the typical financing vehicles for high impact startups, are substantially different from the typical financing vehicles for traditional small and big businesses. A high impact startup with a lawyer who doesn’t regularly represent clients in angel and venture capital transactions will almost certainly find the process more expensive and time consuming than it should be. Worse, I have seen deals that should have been done founder on inappropriate counseling by otherwise quite competent but out-of-their-niche lawyers, both at the closing of the instant deal and later on, when the company needs follow on capital.
4. Finally, lawyers who regularly work with startups understand that most startups are, at various times, cash-poor. That does not mean good startup lawyers are cheap (indeed, good startup lawyers are typically more expensive than their colleagues who focus on traditional small businesses). But they are typically more flexible in terms of their billing and collections procedures than most other business lawyers. Beware, though, both the too-accommodating startup lawyer (their flexibility might reflect limited demand for their services) and the too rigid startup lawyer (their lack of flexibility might reflect a poor appreciation of the financial realities of the startup world).

Rule number two. Pick a lawyer who has the time, talent, experience and curiosity to understand your vision, your business, your markets and your technology. At a larger, more established company, an in-house “General Counsel” is usually charged with making sure the advice of the businesses lawyers, whether in-house or outside, reflects a solid understanding and appreciation of the larger business the advice is supposed to serve. Lacking that filter, high impact startups should make sure their outside counsel can provide that critical “General Counsel” filter.

Rule number three (an extension of rule two, really). Pick a lawyer who can add value to your startup beyond just legal advice. The best startup lawyers I have worked with have all been lawyers who were quite capable of and eager to share their business and sometimes even technology advice with their clients, and beyond that to leverage their own business, technology and financial networks on behalf of their clients.

Now for something to think about, rather than a hard and fast rule. Pick a lawyer – and that usually means a law firm – that can grow with your startup, hopefully to and through a huge exit. My experience includes working with some “small firm” startup lawyers who were quite effective representing their clients in the early stages, and were capable at bringing in other firms for particular matters – litigation, patents, regulatory, etc. – as their startup clients grew and their needs evolved. That approach can be fraught with peril, though, in terms of managing multiple relationships and matters across multiple law firms. In my view, absent a compelling reason to work with a solo or small firm startup lawyer, choose a lawyer with a larger “full-service” firm that has the resources to grow with your startup.

So, my advice on choosing a lawyer for your startup. Self-serving? You bet. But you wanted good advice, right?

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Respect the Stick

The hockey stick, that is.

High impact entrepreneurs know – or learn pretty fast – that most angel and even most venture funds outside of the major venture centers take a perverse satisfaction in telling entrepreneurs that they are being naïve when they build the proverbial “hockey stick” growth assumption into their business plans. A lot of self-identified “smart” high impact investors (particularly those of limited means) can be downright smug in their “you are not another one of those crazy kids carrying a hockey stick” comments as they flip through your pitch deck. “That kind of growth almost never happens.” 

Well, I am here to tell you that the right response to those kinds of remarks – assuming, that is, you really have a venture capital worthy deal – is something like this: “Of course we are – we wouldn’t be here if we weren’t.” 

It is indeed true that most venture-backed high impact startups either never get to the inflection point of the hockey stick growth curve, or if they get that far, fall off the curve shortly thereafter. That, though, says very little more than that most venture-backed high impact startup investments don’t come close to delivering the 10x returns which their venture backers were hoping for when they put their money down. If you focus instead on the deals that do deliver on their home run promise, you will find that most of those did – at some point – reach the inflection point and subsequently crawl pretty far up the growth curve. 

The truth is, if you can’t convince a potential investor that there is hockey stick growth out there somewhere for you, how can you possibly show them a path for a 10x return on their investment? I suppose it might be possible in some cases to do that if you set the pre-money valuation low enough, but if you do that you are probably leaving nothing but crumbs on the table for you and your team. 

No, if you want to raise real money from real venture investors for your startup, you are going to have to project hockey stick growth on some metric (revenue is the obvious one, but things like eyeballs can work in some markets), at some point, in your plan/pitch. An investor who thinks you are too optimistic about when you get to the inflection point on the curve may have a point. And so might an investor be right is saying that your deal will never get to that inflection point. But an investor who thinks hockey sticks just don’t happen, well, that investor just doesn’t understand her own business. Which, I think, is reason enough to look elsewhere for capital. Focus on investors who respect the stick.

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Angel Investing Outside of the Major Venture Centers: Special Challenges

High impact angel investing in the major venture capital centers is not without its special challenges. That said, problems like a target rich environment of experienced entrepreneurs and a plethora of alternative funding options are, as they say, pretty high quality problems to have. Outside of the major venture centers, angels face another set of problems; problems that on the whole make successful angel investing in these locales more challenging than it is for their venture center counterparts. Herewith some thoughts on the special challenges of high impact angel investing in places like the Midwest, and how those challenges might be addressed. 

Challenge: Good angel investing “people” resources – experienced angels, venture investors, entrepreneurs and high impact investing and entrepreneurship service providers – are much scarcer. This makes it harder for the new angel to learn about and keep up with “best practices.” 

Addressing the Challenge: First, try and find locals who have venture center experience and/or perspective, and people who acknowledge and understand the special challenges of high impact angel investing outside of the major venture centers. Focus as well on other angels, lawyers, etc. who not only talk the talk but have a verifiable record of walking the walk.

Challenge: The supply of less sophisticated “wannabe” angel investors and advisers is relatively plentiful. These folks don’t know a lot about the subject, but often think of themselves as experts, and create a lot of noise in the market. 

Addressing the Challenge: Be very careful who you take advice from. Be especially wary of folks who tell you their approach to an issue “isn’t the way they do it in Silicon Valley, but we know better around here. It stands to reason – even allowing for the occasional outlier – that the venture centers are the more likely source of best practices than the hinterlands. Further, no matter how tempting, don’t get sucked into a good deal that a less sophisticated set of local investors have gone into at a ridiculous price. Finally, if you find yourself playing a follower role in a deal led by a local lead of questionable capabilities, discretely do your own due diligence as if you were instead leading the deal.

Challenge: Entrepreneurs outside of the major venture capital centers are generally much less experienced in terms of working with sophisticated angel and venture investors, and building startup high impact businesses. Worse still, they have often sought the advice of well-meaning folks in the community who may have a lot of knowledge about small and big business management and investing, but little or no knowledge of high impact entrepreneurship and investing (see preceding challenge). 

Addressing the Challenge: This a challenge is best thought of as an opportunity in disguise. If (i) you can sort spot the diamond in the rough entrepreneur among all the fools gold; and (ii) you are willing to invest the extra time and energy polishing that entrepreneur; you can often find and invest in hidden gems that other angels either can’t identify or can’t/won’t put the time and energy into value added mentoring. And that can be a great way to get into great investments at below market prices.

Challenge: Venture capital – the primary source for post-angel high impact investment capital – is very hard to find outside of the major venture centers. This is true in terms of the number of investors and the total investable capital under management. And, unfortunately (if not altogether without justification) venture capital investors on the coasts are generally cautious to a fault about the notion of investing in post-seed but still early stage opportunities very far from their coastal homes. 

Addressing the Challenge: Angels in venture-scarce locations must generally include elevated financing risk as a critical part of their investment decision making and management. That can, of course, be one reason deals outside of the major venture centers are generally done at lower valuations. But at least as important, it means that deals should be structured – think in terms of capital needs, early cash flow, and time to exit – to match the likely limited supply of local downstream investors and capital. Focus on business models that call less than $5 million of risk capital and 3-5 years to the exit.

While high impact angel investing outside of the major venture centers is not without it special challenges, so it can have its special rewards. If you are thoughtful about dealing with this challenges, there are good investments to be had at good prices. And, as important for many, an opportunity to help build a high impact entrepreneurship and investing community in a region not already blessed with the same.

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Thoughts on Why Good Venture Investors Turn Down Good Deals

If you know anything about venture capital investing, you probably know that most plans that come across the desks of venture capitalists (and angels, for that matter) are not fundable.  That is, they are of so little merit that no half-way competent investor would back them at any price.

While lots of plans get rejected because they are frankly bad, in my own experience as an entrepreneur, angel and institutional venture capitalist I have been struck by how many fundable deals get turned down by so many competent investors.  (If you don’t believe me checkout http://www.bvp.com/portfolio/antiportfolio, where Bessemer Ventures reviews some of the ultimately hugely successful deals that they turned down over the years.)  Herewith some of the reasons good venture investors turn down good deals.

Fundable deals are often turned down because a fund is out of dry powder, defined as fund capital not already invested in, or set aside for, current portfolio companies.  The “set aside for” phrase here is the one that sometimes confounds entrepreneurs.  When a (competent) venture investor puts say $X into a startup the investor almost certainly makes a mental note to reserve another dose of capital for future investment in the company.  That number, let’s call it $Y, can vary from deal to deal, and over time as a particular portfolio company, and the fund’s portfolio, evolves.  That said, a good rough assumption is that if a fund has actually invested 50% of the capital in its active portfolio companies the fund is likely “fully invested” and thus does not have any dry powder available to commit to a new deal, like yours.

(Why, you might ask, would a fund bother talking to an entrepreneur if the fund doesn’t have any dry powder available to do the deal in any event?  First and foremost, because venture investors want to stay current on market conditions and deal flow wherever they are in terms of their own investing cycle.  In terms of managing their current portfolio investments, keeping up with emerging competitive trends is, of course, useful as well.  And in terms of thinking about raising their next fund, staying current is critical to their own fund raising pitch.)

Funds also commonly turn down a fundable deal because it doesn’t fit with the fund’s investment strategy or theme.  Most fundable deals that are out of the comfort zone of a fund – say a biotech deal getting turned down by a fund that focuses on the IT space – get turned down without a time-wasting reading of the plan, much less a meeting.  Now and then, however, it takes a fairly close look to see that a deal doesn’t quite hit a fund’s sweet spot.

Which leads to two other reasons fundable deals get turned down.  First, a benign and quite common one.  No one at the firm, after reading the plan and taking a meeting, is excited enough to do any more work.  I am an investment adviser to a small angel fund, and a couple weeks back we looked at a pretty well put together plan for a business that was clearly in our sweet spot.  Alas, while we liked the entrepreneur, and the plan was technically pretty solid, no one on the investment team was really excited about the deal.  At a gut level, no one “got it.”  That may not seem like a very good reason to turn a deal down (“yeah, well, I can’t really say why, but it just doesn’t excite us”), but it happens all the time.  Good investors won’t do a deal just because they like it at a gut level, but they almost never do a deal that they don’t like at that level.

Next, something for the conspiracy theorists in the audience.  Most venture investors that I have known, even many of those wearing more or less white hats, will happily spend some time with an entrepreneur who passes the blush test and also looks like a real or possible competitor of one of their portfolio companies.  Most won’t try too hard to solicit information they shouldn’t, but neither will they tell a talkative entrepreneur to keep quiet.  If that seems unfair, well, no one ever said life – or high impact entrepreneurship – is always fair. (If this makes you think you should get an NDA before you have a first meeting with a venture investor…., think again.  For some good, bad and indifferent reasons, VCs don’t sign NDAs.)

Perhaps the “best” reason a fundable deal gets turned down, if also maybe the most frustrating for the entrepreneur, is the “really good deal … but we can only do so many deals and, well, we have another one we like just a little bit more” turn down.  The fact is, even funds flush with cash can only do a limited number of deals.  Both capital and people resources are finite, and the better the quality of a fund’s deal flow, the more good deals they turn down.

Finally, your deal might be one of those that get turned down because the venture investor in question just plain made a mistake.  As, for example, Benchmark turned down PayPal.

So the next time your presumably fundable deal gets turned down, you can take some solace in the notion that most fundable deals get turned down.  Indeed, unless you have a solid track record making money for venture investors before, you should plan on a lot of turn downs before someone recognizes yours as a deal that they just have to do.

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Understanding the Limits of Convertible Debt Seed Financing Structures

While Convertible Debt with a “kicker” of some sort (typically either in the form of warrants or a discount on the conversion price) was first used primarily as a structure for bridging companies between rounds of traditional venture capital financing, more recently it has become a popular vehicle for seed financing in advance of the first (“A”) round of venture investment.  The structure offers two major plusses for entrepreneurs and investors.  First, it postpones the valuation negotiation until both parties have a better handle on the key variables.  Second it is faster and cheaper to implement than a formal Series A round.

That said, like most ideas that have been around for a while, convertible debt has found its way into more situations where it may not be a very good fit.  Today, my focus is exploring the situational limits of the convertible debt financing structure in the startup context.

Conceptually, the convertible debt structure works when an entrepreneur seeks a modest round of risk capital to achieve a significant milestone in a short period of time, the accomplishment of which will set the stage for a substantially larger subsequent A round of financing.  Framed this way, the terms “modest” and “substantially” are linked, while the terms “significant” and “short” are more or less independent.

Let’s start, then, with the “modest” and “substantially” discussion.  Essentially, the notion here is that the bigger the difference between the seed round need and the A round need, the more a convertible debt structure makes sense.  Depending on the kind of deal (think bigger in capital intensive businesses) and the seed capital market (think bigger in venture capital centers) a convertible debt seed round might be anywhere from $5k to $1 million or more.  The critical point is that the expected A round be substantially larger.  How much is that?  My thinking is that in general the A round should be at least 2x and ideally 3x or more the size of the seed round.

The reason the A round should be at least twice the size of the seed round is that if the seed round gets much bigger the impact of the seed round kicker on the A round valuation negotiation will at some point cross the fuzzy line from marginal (and thus largely overlooked) to central (and thus problematic).  For example, consider a $500k convertible note with a 20% discount on conversion.  If the subsequent A round is a $5 million raise, the seed round kicker (basically, the seed folks will get an extra $100k worth of A round stock) represents roughly 2% of additional dilution to the A round investors.  In theory the A round investors might factor that 2% into the A round valuation discussion.  In practice, probably not.

On the other hand, if the A round in the above example is just $1 million, the overhang from the 20% kicker looms much larger.  In fact, it now represents roughly an additional 10% dilution to the A round investor.  At this point, what was a theoretical issue for the A round investors, in terms of the valuation negotiation, might be a practical issue as well.  As such, it will likely complicate the A round valuation discussion, and likely result in a lower A round valuation – and corresponding additional dilution for the entrepreneur.  (Alternatively, some or all of the additional dilution might be shared with the seed round investors, if they can be “persuaded” to waive some or all of the seed round kicker.)

Let’s turn now to the “significant” milestone variable in the seed convertible debt scenario.  What constitutes a “significant” milestone?  Essentially, two related concepts play into what constitutes a significant milestone.  The more central of the two is the notion that significance is measured by how much risk the accomplishment of the milestone takes out of the deal.  Particularly at the early stages of a high impact business, the primary driver of value is risk reduction.  The seed milestone should be well-defined, and the accomplishment thereof should reduce the risk that the deal will get to a satisfying exit by … say 25% to 50%.  (That might seem like a lot, but really just reflects how risky high impact entrepreneurship really is.)  In addition, though in fact another way of framing pretty much the same issue, the accomplishment of the seed milestone should provide a much firmer foundation for the valuation discussion at the A round.

In my own world, I see a lot of web-centric startups where the seed round milestone is the delivery of  the proverbial minimally viable product coupled with some modest customer validation.  The significance of the same – the transformation of the entrepreneur’s idea into an actual product that at least a handful of folks in the target market will buy – is pretty obvious, both in terms of risk reduction and firming up the A round valuation parameters.

Finally, let’s consider the “short” time variable in the seed convertible debt scenario.  This is in some ways the trickiest variable, I think, because it doesn’t so much depend on the practical demands of the convertible debt structure as the extant market dynamics.  By that I mean that the bounds of the time variable are more a function of the market’s determination that an acceptable seed round kicker is something between 10% and 30% than any conceptual limits on the amount of time expected between the seed round and the A round.  The notion here is that the seed round investors will accept a relatively modest 10% to 30% kicker on the assumption that the return will be over a reasonable period of time.

What is reasonable?  In my experience, no more than 18 months, and generally less than 12 months.  Why?  Because if the implicit rate of return on the seed debt falls too far below the expected A round return (which might eye-balled at something like 100% from A round to B round) the seed round investors will quite rightly wonder whether their generosity in providing seed capital with only a modest kicker has crossed into philanthropic territory.  And while I have known a lot of seed investors who think giving back some of their own good fortune by supporting the next generation of entrepreneurs is a wonderful thing, I have not found many who think giving away their good fortune to a next generation entrepreneur is a good thing.

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Act 255 Tax Credits and …. Convertible Equity

Active angel and venture investors in Wisconsin are generally familiar with Act 255, a state law that provides a tax credit for investors in the equity of qualifying emerging technology businesses.  In cases where an investment is made before a company receives Act 255 certification, the investment often takes the form of convertible debt: the Act 255 credits are triggered when the debt converts to equity – presumably after the company is appropriately certified.

While convertible debt is a wonderful vehicle for accessing the Act 255 tax credit in the above scenario, what about the situation where a company is Act 255 certified but the preferred investment vehicle is convertible debt for other reasons (most often, to avoid having to establish a valuation)?  In this case, if the conversion to equity takes place in a tax year subsequent to the year of the investment, the investor does not get to claim the tax credit in the year of the investment itself, but rather in the later year when the debt converts to equity.  Not good.

One way to avoid the delayed receipt of Act 255 tax credits in the above scenario is to make the initial investment in the form of convertible equity, rather than convertible debt.  All of the important features of the convertible debt structure – including postponing the valuation discussion and the provision of a “sweetener” to the convertible security investors – are retained, and the company will not have any debt on its balance sheet.  Voila – the investment being in equity, the investors get the Act 255 credit (assuming, again, that the company has received Act 255 certification) as of the date of the investment.

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Thoughts on Convertible Debt Valuation Caps

Convertible debt with an equity kicker – typically either in the form of warrant coverage or a discount on the conversion rice – is a common vehicle for seed stage financings.  As people on both sides of these deals have become more familiar with the convertible debt structure, a number of bells and whistles have begun popping up.  One twist is the notion of a cap on the conversion price of the debt.  As of today, valuation caps are included in most West Coast convertible debt deals, and are becoming more common in the Midwest.

While valuation caps may be here to stay, entrepreneurs and investors alike should understand when and how a valuation cap might negatively impact downstream financing.

First, it is probably worth asking why the “market” seems to be moving towards the regular use of valuation caps.  The answer, I think, is that the same market seems to have settled on an equity kicker in the 10%-30% range: that is, whether the kicker is in the form of warrant coverage or a discount on the conversion price the effective kicker in most convertible debt seed rounds is somewhere in the 10% – 30% range.

Assuming a very common 20% for the kicker, what is the problem?  That is, why with a 20% kicker, should a seed investor also want a capped conversion price?  Two situations come to mind, the first understandable but ultimately not very persuasive, and the second understandable but somewhere out there in “what would you do if you won the lottery” land.

In the first case seed investors use the valuation cap to try and end run the 10% to 30% market price for the convertible debt kicker.  And for good reason.  Be honest, here, Ms. Entrepreneur: capping a seed investor’s return at 10% to 30% from the seed round to the A round is pretty, well, parsimonious.  Considered in this context, the point of a valuation cap, from the investor’s perspective, is to juice the return.  That is, the idea is to get a cap below the likely A round valuation, so that the cap will have the effect of juicing the kicker on the seed debt.

Assuming juicing the convertible debt kicker is the point of the cap, what is the problem?    Well, the same problem that would exist if in the alternative you just bumped the basic kicker from the 10% to 30% range to say 50%-100% range.  The extra juice would likely be too much added dilution for the A round investors to accept.  A round investors can generally live with seed kickers to the extent they, at least in terms of optics, don’t seem to undermine the fundamentals of the A round price.  But when a kicker starts changing the fundamentals of the deal – that is when the seed round is either too large (say more than 1/3 the size of the A round) or the kicker too big (say more than 30%) – the dilution from the seed round at conversion begins to look more than marginal and the A round investors will likely start pushing back.

The second, and I think much more convincing, rationale for a cap on the convertible debt conversion price is the “what if we win the lottery” scenario.  Here, the point of the conversion price cap is to protect the investor if the A round price ends up being far beyond what either the seed investor or the entrepreneur might reasonably have expected when the seed round closed.  So, for example, consider the typical situation where a seed investor puts in $100k with a 20% kicker, on the assumption, shared by the investor and the entrepreneur, that if the deal goes well the A round will be priced at, say, $3-5 million pre-money.  What happens if, between the seed closing and the A round the entrepreneur catches a venture capital thermal and suddenly finds herself looking at an A round pre-money north of $15 million?  In this scenario, the point of the seed conversion price cap is to make sure that the benefits of the unexpected windfall are shared by the seed investor as well as the entrepreneur.  And I think, at least, that such sharing seems entirely appropriate.

That leaves one question.  What, in general, is a “fair” conversion price cap?  Given that the “good” rationale for a conversion price cap is to share an A round valuation windfall, the question becomes what constitutes an A round windfall.  I don’t know that there is a “right” answer to that question, but my sense is that 2x what the seed investor and entrepreneur reasonably thought the upper end of the A round price range would be at the time of the seed round.  In the example in the prior paragraph, that would be $10 million.

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Entrepreneurs with (Bad) Attitudes

Many high impact entrepreneurs have outsized personalities.  They combine a big ego with incredible creativity, drive and energy.  Pretty much all of them that I have known have had at least one serious personality … quirk.  That said, there are quirks and there are flaws, the latter being defined, for my purposes here, as traits that rub most venture capital investors the wrong way.  Herewith, some of the entrepreneur archetypes most venture investors try to steer clear of.

The Defensive Entrepreneur.  Defensive entrepreneurs take everything personally.  When an investor asks them a probing question, they assume they are being asked to justify their existence.  And that tells the investor that the entrepreneur is more concerned with proving himself than his vision.  These are the folks who fear just one thing more than they fear that their startup might not work: that it might work with someone else calling the shots.

The “There is No Competition” Entrepreneur.  If, perchance, a bona fide entrepreneur comes along someday who really doesn’t have any competition, I’ve got a very important piece of advice for her: make something up.  Because entrepreneurs who insist they don’t have any competition almost never get funded.  There is always competition for the customer’s dollar.  A good entrepreneur understands that every potential customer ultimately must be won with a better value proposition.  Better than what?  Better than the competition.  Sometimes the competition is obvious; sometimes less so.   But it is always there.

The God Complex Entrepreneur.  The prototype here is the tenured well-published academic.  Having made a name for themselves in the very demanding, cutthroat world of academia, these folks assume they must perforce be capable of building the next Merck in their spare time.  Alas, as even Michael Jordon found out, different sports are, well, different.  Being good at running a research lab is no more a proxy for building a business than being a basketball superstar is for being a major league baseball player.

The “I Can Do It All” Entrepreneur.  A cousin of the God Complex entrepreneur, the I Can Do It All entrepreneur doesn’t understand that even if he could do everything himself actually doing everything himself is always a bad idea.  Great entrepreneurs know that they need to focus all of their energies on those mission critical things that they are best at, and find and empower other folks to do the other stuff.  Like the captain of a ship, an entrepreneur is responsible for everything that gets done (or not) on the ship.   But they don’t actually do everything.

The Big Business Entrepreneur.  A lot of personal regrets with this one.  If you think that someone who can run a billion dollar business can necessarily run a startup, think again.  And again.  There is not all that much overlap between building a successful business from scratch and managing an established successful business.  Being good at the one is thus not a very good predictor of being good at the other.  In fact, being good at running a big, established business is more likely to have a negative correlation with being able to build a high impact startup business.  Beware of any entrepreneur who needs a personal assistant.

The Uneducable Entrepreneur.  This can be a tough one to spot, but in an age when most startups need to pivot at least once on the road to success, it is an important one to spot.  What makes this a tough entrepreneurial species to identify is the fact that most successful entrepreneur are “often wrong, but never in doubt.”  And that trait can too easily be mistaken for a lack of learning ability/willingness.  Really good entrepreneurs may not always acknowledge their mistakes (though many of them do) but they clearly learn from their mistakes.

No doubt there are rule proving exceptions to each of the above paradigms.  But all other things equal, if an entrepreneur can be fairly fitted into one of the above categories, they will find raising capital from smart investors more difficult than it would otherwise be – even if they are one of those exceptions.  So why make it tougher than it has to be.  Just stay out of the “bad attitude” neighborhood.

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