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    3 Replies Latest reply on May 30, 2008 12:10 AM by PeoplePawn

    Getting funded and alternatives. I have run the gamut.

    SEOpro Adventurer
      Parts of this article, people have told me, sound a little bitter. I'm sorry if I haven't gotten over some of it, but I do hope there are some lessons in here others can use to avoid some mistakes I made... but perhaps life never works like that. I am told if you are in a pre-funding startup, there's goodness in here for you.
      - Liam

      Summary:
      First-timers in starting up worry about things like (1) competitive products, (2) competition stealing their ideas and (3) VCs divulging their precious secrets, (4) how much of the company they can retain, etc..

      Those experienced at starting up focus on (1) how to deliver ever-increasing value to customers and (2) internal execution to achieve that while staying liquid.

      A second point:
      When it comes to a bacon-and-egg breakfast, the chicken is involved but the pig is committed. With VC investments, the VC investor is involved but you, the entrepreneur, are committed. The typical VC investor has a portfolio of maybe 10, 20 or 30 companies. You have, most likely, only one. If it fails, it takes your single five to ten year investment in time and effort down the drain with it. You lose your whole portfolio, and the VC company goes on.

      The Details:
      I'm well into my fourth real startup. I started a software company in 1994 which ran for three years, and another software company in 1999 which is still in good business, and in 2005 I started a hardware product company. The fourth is an SEO services company.

      The first company, I started with two partners, the second with one partner and the third and fourth I started alone.

      We never managed to get financing for the first company, mostly because we didn't have a clue how to go about it.
      I was the product guy and one of my partners was a well-rounded business development and marketing guy. Happily, he is a close friend of mine to this day.
      The third partner fell apart early on in the startup, so we were quickly down to two. I am told that happens a lot.
      With two versions of two software products, we secured some several hundred customers over the 3-year life of the company. We didn't make a lot of money out of it, but got some badly needed startup experience.

      It is no surprise to me that the vast majority of new companies fail pretty quickly.

      After Startup #1 eventually sputtered to a halt, I went back to the workforce with a little hard-earned but valuable humility regarding making a business successful.
      Within 18 months, I was smitten with the possibility of starting another software company. That eighteen months gave me the time and space to think hard about the lessons I learned and I religiously applied my newly learned principles to Startup #2.

      For almost two years, my co-founder and I buried ourselves in his basement, cutting as much code as we could before cash or motivation ran out. We were fortunate to stumble upon a very sharp fund-raiser to whom we offered the position of CEO and significant partner. Over the course of 4 or 5 years, our new CEO deftly secured three rounds of financing at a good price every time.
      I learned a few things during those 4 or 5 years.

      I'll talk about startup #3 a bit later.

      What are the ramifications of getting funding for your startup? Getting funding for your startup has a number of implications that founders typically don't understand.

      #1: Liquidation Preference
      In addition to how much stock you retain in your own startup, Liquidation Preference affects how proceeds are divided up in the event of your startup being acquired.
      Almost always, the VCs who put cash into your startup have a "2x Liquidation Preference". This means that they are entitled to get twice their investment back before you get paid anything, in the event of an acquisition.
      That's just the theory, of course, and some of it is still open for negotiation, depending on how the company is doing, and other factors.

      Let's look at a theoretical example.
      You have an equal partnership with your co-founder. Investors want to invest $10m into your startup, and for that, you agree to give them 40% of the company. This means the company is "valued at $25m" in terms of what is called "pre-money". (If 40% = $10m, then the company should be worth 40% + 60%, you'd think. "Pre-money" means 'before the investment is made').
      So now you and your co-founder have 30% each of a company that is worth $25m (on paper) and has $10m in the bank.

      Yippee!

      Not quite Yippee.

      Your investors have what is called Preferred Stock. You and your co-founder have Common Stock. Preferred Stock has typically a Liquidation Preference associated with it and Common Stock does not.

      Aside from money speaking louder than words, Liquidation Preference is there for a number of reasons. (1) it discourages founders from forcing a sale at a price at which Investors would lose money (imagine a week after the investment, you got an offer to sell the company for $10m) (2) it forces the Common Stock holders to increase the value of the company to a number where it makes investment sense for the Investors. There are other reasons too, but I'll get back to that.

      It's great to get all that cash injected into your startup. Overnight, you go from scrimping and scraping to make ends meet, to getting paid a salary and still being able to pursue your brilliant idea. You are, as my friend Randy put it, betting with house money.

      Pigs get Fat; Hogs get Slaughtered
      A risk with this model is, with every round of financing, you significantly raise the acquisition price required for the Common Stock holders to make any money. After the first round, you have to sell the company for $50m in order to satisfy the Investors with their 2x Liquidation Preference. Mind you, if you do sell the company for $50m, and you still have 30% of it, you're in good shape.
      The problem is, it will take a long time and a lot of effort to double the value of your startup to reach that $50m. And the journey to get there is fraught with danger.

      Rule of thumb: a 2x Liquidation Preference = 2x the company price must be.

      You'll have to bring out newer, better versions of your product or products, reel in more customers, get process in place and generally prove to the world that your company is growing. A lot of things can go wrong in that time. And when they do, you can't just make a few phone calls and secure another $10m to take another swing at it. Or rather, if you do, you'll have to give away another big piece of the company, perhaps even more than 40% if your company is having troubles. Having company troubles means that you might need a "down round". A down round is where you give stock away at a price that is less that the previous investment price. If you have to give away another 60%, everyone loses 60% of their share of course, investors included, but your Common Stock, now at maybe 10% of the company, needs a significant acquisition purchase price before you make a dime.
      The biggest problem with Common Stock is, your share of the company is "diluted" with every round, so you have to continue to be successful every year of the startup. One bad round and you're what they call washed out.

      Question: What makes a company work?
      Answer: Creating customer value.

      In the long run, you must create customer value in order to stay in business. You must deliver something to your customer that they feel good about paying for...something they get a multiple of the value for. Profit will eventually come if you continue to increase customer value, but customer value will not necessarily come as a result of profitability.

      #2: A Conflict of Interests - Investors versus Founders:

      The typical VC investor invests in many different companies at roughly the same time. They might have investments in twenty different startups chugging along and as long as two or three of them turn out to deliver bumper returns, most of the others may evaporate, yet still the VC is in excellent shape overall.

      Not so for the lowly entrepreneur who is strapped to a single company.

      The typical entrepreneur has his or her retirement buried in the startup. Or at the very least, has bet a lot on a successful return from the startup. Yes, the VC might have poured $10m into it, but as soon as it looks like it is, as they say in the vernacular, going south, the VC tends to shift focus towards the prosperous companies in his portfolio and away from the troubled one. The mathematics of the VC's investment portfolio makes him or her unmotivated to deal with hard issues in the startup.

      This inherent unwillingness to make hard choices, coupled with the fact that their Liquidation Preference protects them from an entrepreneur selling the company at a fire sale price, puts the entrepreneur into a vulnerable position, one that is not obvious before problems arise.

      How can an entrepreneur protect himself/herself?

      To be fair, when an investor sticks millions of dollars into your idea, he/she is making a huge commitment. You will probably draw a salary and pay into your retirement fund while you work your idea at their expense. That is a significant commitment they are making to your dream.

      Still, you should understand the mathematics that make you vulnerable in ways the investor is not vulnerable.

      Taking investment into your startup does not decrease risk. It delays risk.

      The pros of taking investment:

      * You get to draw a salary.
      * You get to apply extra resources into your startup.

      The cons of taking investment:

      * You need to sell the company for a much higher $ figure for you to make anything.
      * You introduce a lot of complexity into your startup.
      * You lose significant control over the direction of the company and everything in it.

      The Never-ending Illusion of Almost Acquired
      A lot more companies get sold for $3m than get sold for $10m, or $30m, or more. The higher the number, the fewer companies get sold for that amount, the less likely you can strike a sale, statistically speaking.
      What's more, many companies get the opportunity to get sold as a technology play early on, before the startup really becomes a company. After that, there can be a long, parched road before another opportunity to get sold appears.
      This means, whilst you may have had an opportunity to sell the company for $5 - 10m, you may not get another chance to sell it before it passes well beyond the $100m company value range. There is a big difference between having a product and having a company. There is very little in between that a potential acquirer will be interested in taking on.

      If you are a Product Builder, which many entrepreneurs are, and you are not a Company Builder, which many entrepreneurs are not, then you might be successful at building your initial product, at which time your startup will be worth something, and selling it to the first suitor.
      After that, during the steep learning curve of you learning how to build a business, you may fritter away lots of the hard-earned company value you accrued early on, and end up diluting your value by effectively investing your hard-earned value (you built a product) into something which is not your specialty (building a company).

      Moral #1: Always be selling your stock.

      Moral #2: Start a business that does not require significant investment, but does exploit your specific skill set.

      For all the assumed goodness that millions of dollars brings to your startup, the fact is, things quickly get more complicated with all that money involved. Suddenly, there is serious time pressure to deliver. Sure, everyone wants to be successful quickly, but now that your company has taken the VC money, your investors are anxious for you to burn the midnight oil and give them a return quickly.

      In many cases, another 40 engineer bodies on the problem will only make a marginal improvement to your chances. Often, VC investment in a software company is a exercise in posturing. With software in particular, you might actually be better off limited to the original two or three engineers working the problem. Sometimes just a few hours work every night, while you keep your day job, is enough to keep the startup progressing enough, but takes a lot of other pressures off. For instance: (1) you can keep the price of the software at whatever you think is right, even free, if that gives some advantage (2) you can mull over some decisions for a long time before making them, (3) only perform the key improvements that you know will add value. But most of all, when you get an offer from someone to buy out the technology, a few million will probably be very attractive to you. There are MANY big technology players out there who will fork out a few million just for the chance to try out your fledgling product in terms of an acquisition.

      You see, people think, just because they suddenly have this $5 or 10m in the company coffers, their chances of success are suddenly improved.
      They're not really.
      The risk of failure is simply postponed, or simply exchanged for a different kind of risk.

      So, when you take a big investment from a VC company, understand that it brings with it significant risks that are not obvious when your company deposits that check into its bank account. Think long and hard before you strap yourself to that Big VC Rocket.
      Once you do, there is no turning back.

      I wish you good luck, no matter what.
      Liam
      www.siteleads.net when I'm at work.
      Or email me at liam.scanlan@gmail.com if you like.
        • Re: Getting funded and alternatives. I have run the gamut.
          PeoplePawn Wayfarer
          Great article Liam. Well thought out and documented. Thanks.
          • Re: Getting funded and alternatives. I have run the gamut.
            EL_DollarShop Adventurer
            Well done article, for you to write your opinion.

            Man did you get screwed? Because it has a hint of overtone that you are angy at being someone that went in feet first into the pool that had no water in it yet?
            • Re: Getting funded and alternatives. I have run the gamut.
              PeoplePawn Wayfarer

              Liam:

              I know you well as a fellow entrepreneur, friend and service provider to PeoplePawn.com. With those same facts in mind, I know how you think. I know there is no "bitterness" portrayed in your blog....just "real life", "matter of fact", reality. The facts are that 99% of the readership in this platform have little to zero tenure in the "real world, multiple start-up experience"....which is why your background, experience level and perspective is so important. Fewer have "self funding" experience, even fewer have any "angel experience" and I challenge anyone here with the exception to yourself, that have any "venture capital" experience".

              Please continue to write in the context that you do. You'll continue to be professional, relevant, informative and valuable to the vast majority of the readership.

               


              As a serial entrepreneur, I continue to learn from your content.......I think the majority of the complete BOA forum is behind me in my logic.

               


              Regards,

               


              Patrick Kane - Patrick@PeoplePawn.com
              www.PeoplePawn.com