Tuesday, August 21, 2007

Startup to IPO: Is the VC you’re presenting to interested?

If you haven’t read Guy Kawasaki’s post “The top 10 lies of venture capitalists” – read it first. I howled with laughter when I read it. And yes, it’s true.

I’ve raised my fair share of venture capital in six rounds over the last 10 years. And have probably given at least 100 (thinking about it maybe 150) pitches. Plus the pitches necessary for my IPO (definitely over 100 there). I've also sat on the VC side for at least 20 pitches and watched partners reactions to enthusiastic entrepreneurs.

My rule of thumb is: if you don’t get a very strong indication of interest in the FIRST meeting, where the VC really engages you, with enthusiasm, about your business idea, customers, market and technology (the interesting stuff that matters, not terms which really don’t until you have a live one) and where he has a clear vision of the next steps, then it doesn’t matter what words come out of his mouth – you’re not getting his funds money.

I was written up in the San Jose Business Journal this week and my current lead investor, Bandel Carano, is quoted as saying that he “agreed to finance FirstRain after a short one-hour meeting”. It’s true. I actually timed him and he gave me terms after 45 minutes. This is in stark contrast to many meetings I had had where the VCs did not understand financial services (odd since they are in it, but there you go) or search (except for Google which everyone wants to repeat but few understand it is just one (very successful) version of search) and so while they’d say many of the things Guy quotes I knew they were not going to bite. While it’s unusual to get terms as quickly as we did with Bandel, it is terrific as an entrepreneur to have investors who can make decisions fast. Yet again I believe it’s as important to assess the VC as a potential member of your team as vice versa - see my post All Venture Money is Not Created Equal.

Entrepreneurs often have happy ears. They hear what they want to hear. Sometimes you have to in order to keep going. Otherwise it would be too hard to get the energy up to sell to yet another group of VCs who don’t really get what you do and are listening only because they don’t want to miss out just in case you've got a hot company.

But, I would add, VCs also have a herd mentality. They’ll wait until someone else puts down a term sheet. So, if you do need more than one investor to fill out the round then it’s worth keeping all the folks on the sidelines warm to come back to – although in my experience if a tier 1 VC really likes your deal he won't usually want to share in his first round anyway.

(A related observation. Reading Guy’s blog he’s very balanced about using “he” and “she” when referring to VCs. There are so very few women in the business that I have only ever presented (twice) to female partners in firms that have already invested in my company. But, I applaud Guy’s imagining a different VC demographic than we have today).

Monday, August 20, 2007

The French know how to live

I just returned from 2 weeks in Europe, 1 week of which we spent in an 11th/14th century chateau south of the Loire. It’s heavenly to live the life of the French gentry. Beautiful surroundings, nothing much to do except go to the market (and the charcuterie, and the boulangerie), cook, eat, drink, hike, bike, swim, read and visit the occasional chateau or ruin.

Coming back into work in the Bay Area this morning, back into the intensity of a search startup, was hard. I highly recommend escaping to the rural lifestyle for a while as a means to maintain sanity when running a young company.

Tuesday, August 14, 2007

Startup to IPO: Building great talent

No question from my point of view – the single most defining characteristic of a great company is the strength of the leadership team. Are they all world class? No matter what the size of your company – you assess each executive and whether they are at a world class level for the job you have them doing. If you can answer yes to this question then you have a strong team; if not I think it’s high time to replace the ones that you cannot defend to any challenger and if your company is growing fast you also need to get comfortable with parting ways with executives who don’t scale.

The recent business week article The Five Faces of the 21st Century Chief names the style of CEO style I strive for as “The Casting Agent”. This makes sense to me (although I probably display some “Conductor” characteristics as well). Think of great movies; the best shine because of great actors and a great director – working well together. It’s like that in a company too. Sometimes the CEO is the producer (raising funds, managing the team), sometimes the director (calling the plays in detail), sometimes both.

So the challenge as a CEO is to hire people who are better than you in their field. Sometimes it is hard for new CEOs to have the confidence to do that – and it takes confidence to lead a room full of people who are better than you in their field. It also takes trust – as covered in my June post on trust – because they can make your life tough if they want to and then you have a whole different problem to solve.

The job is particularly hard for public company CEOs today. I sit on the board of Rambus and watch first hand the tremendous challenges placed on the CEO, Harold Hughes. Today, public company CEOs have to not only manage the company itself, but also manage much more attentive boards, auditors (who are a whole class of issue themselves) and appropriately demanding investors. Given the breadth of challenge I think the only answer is to be a great casting agent and build bench strength in your team.

Sunday, August 12, 2007

Startup to IPO: Valuing a small company for angel investment

(I am writing this post from a small, 11th century chateau that we have rented in the Loire Valley in France. My room is at the top of a tall tower accessed by a stone spiral staircase and I am looking over a beautiful, peaceful river valley. The chateau is picture perfect – from a fairy tale – and my kids and their cousins are in heaven. The French really know how to live…. but even a fairy tale castle has broadband so I keep going ….)

I was approached for advice by the founders of a small company that is building models for hedge funds. Their company is just breaking even but they need cash to expand it to cover the segment of the market they have identified – so their question was how to justify valuation to a prospective investor. I sent them email with my rule-of-thumb and they found it useful so I’ll share it here:

“Valuation is usually a function of stage and expected size ~5 years out. Angel investors often want 5X return knowing that their company is likely to be sold, VCs will usually want to see > 10X return for a high sales price or IPO, but know that only 1 in 10 will make it big.

So in your case I think it depends what the size of your market is. If you are very successful how many customers and how much revenue will you have? Then you can calculate valuation. If your revenue is service revenue (very people dependent) valuation is usually 1-2X last 12 months revenue (LTM), if you have a product that sells for one time revenue and then annual maintenance then valuations are often 3-4X LTM, if you have annual recurring product revenue (like a SaaS model) then valuations can be 8-10X LTM and if it's a really big idea, growing at >50% per year it can be 8-10X next years expectation. In the “big idea” case what a long term investor is valuing is long term expansion of earnings.

So build a model for how much you think you're worth 3-4 years out and that will give you guidance on whether a fair value today is the number your investor has in mind or the number you have in mind.”

Wednesday, August 1, 2007

The Need for Soft Dollar Transparency

There was a recent article from the Wall Street Letter (subscription required) highlighting activism by the Securities Traders Association and the Alliance in Support of Independent Research on behalf of soft dollars as a response to SEC Chairman Cox’s personal comments in the WSJ in May against the practice and it caused me to rethink about my own views on the subject.

The whole concept of “soft dollars” is unique to the money management industry. As an investor, I know that I get charged management fees as a result of my relationship with an investment firm – seems fair given that I am receiving a service. These fees are supposed to cover the firm’s operational costs to manage my money – including the purchase of research. But firms then use soft dollars as additional currency for research on top of my fees. So how do I know that I am not paying too much in management fees since I can’t see the soft dollar benefit? I think Chairman Cox’s previous sentiments get to the root of this problem for the typical investor.

As a CEO of a company serving the buy-side, I clearly see the benefits of soft dollars. FirstRain is a research service; according to the SEC (we double checked this with our attorneys) it is fully acceptable to use soft dollars to pay for our services. And many of our clients do – regardless of assets managed, hedge fund or mutual fund. In addition to the large names like Pioneer, we have a growing number of smaller investment firms that see FirstRain as an extension of their research process – as a way to compete with larger firms that have more money and resource available to them.Soft dollars are able to help level the playing field for them. And for FirstRain, as a small emerging alternative research firm, we are able to get paid more quickly through our relationships with the broker-dealers than if we had to wait for direct payment. I should add that some of our clients who are the largest institutions use hard dollars to pay us.

So how can there be a win-win-win for investors, the buy-side, and research providers with regards to soft dollars? I think the solution is transparency. This is what the FSA decided in a U.K. ruling in late 2005 and it would make sense here in the U.S. The buy-side needs to tell their clients how their management fees are used and where the soft dollars are going and to do this the broker-dealers just need to disclose to the buy-side the break down of what comprises the “commission” so the buy-side can pass along this information to their clients.

Maybe it’s more complicated than this but it seems that if we all followed the spirit of why soft dollars were approved in the first place, and we gave investors transparency as to how their fees are being used, we all can continue to benefit from the soft dollar mechanism. If you have further interest in this topic, my friend Sandy Bragg at Integrity Research Associates and his colleagues regularly blog on this issue.

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