Venture Beat: FF Class Stock for Founders

FF Class Stock for Founders 

A form venture capital funding in Silicon Valley is getting increased interest from founders of start-ups.

It is called the “FF class” of stock, for founders who want to cash out a small percentage of their stake in a company so they don’t have to wait until the company is sold or goes public.

This practice is not entirely new. Many founders through the decades, including at Intuit years ago and Jonathan Abrams at Friendster more recently, have sold shares in their company to their venture backers and gotten cash to enjoy life a little more. But with the favorable start-up climate now, VCs are doing more to accommodate founders, entrepreneurs are getting more sophisticated, hearing more about these sorts of terms, and increasingly asking for them.

Raising money in good times

New VC Strategies: Venture debt or angel money?

Alex wants to grow up and be a VC.

(Possiblly so he can afford to hire personal protection and prevent further beat-downs.)

 Here's Alex's idea for funding startups:

"If I like the entrepreneur and the company or idea, I will fund it, up to a certain amount, using the following simple formula (sample dollar amounts only, actual invested dollars will of course vary):

Amount Invested = $250,000

I own 75% for my cash investment, entrepreneur owns 25%.

The moment I receive my $250,000 back with a 20% increase (for a total of $300,000), the equity flip-flops. I own 25%, the entrepreneur owns 75%.

This simple method allows for a few things to happen. First and foremost the entrepreneur is highly motivated to get my initial investment plus interest back to me as fast as they possibly can. I don’t care how they do it. Bank loan, profits, home equity line, friends and family, outside investor - it doesn’t matter. Once they pay it back, they own their company again, until then, I own it. I don’t want to run it or mettle in their business. In fact, I won’t do that. But the fact that I own 75% will motivate any entrepreneur worth their salt to hurry up and change that around.

When they pay me back, I will still get to participate in their company as a shareholder, and hopefully I can add value as a 25% owner. They will be in control though and I will be along for the ride.

Why is a 25% equity stake in your company too much to ask for funding the entire business with no personal risk on your end? All i make is a 20% return..."

Ok Alex, you asked for it.
Let's take a look at a situation like this from the entrepreneurs perspective. 

What you're offering is venture debt with a few unusual caveats.

• You'll lend money without a personal guarantee on flat rate terms of 20% for which you take 75% of the equity.
• You'll take a 20% return.
• You'll keep 25% of the company.
  

So here come the problems: 

• Why would I take on venture debt for a 25% stake (if everything works perfectly) when an angel will take the same equity postion up front  (typically 20-30%) without ever taking control of the company.
  
• When does the 20% have to be repaid?
• Say the company is growing fast. You own 75%. What would prevent you from wresting control of the company from the entrepreneure minority shareholder?
  

You're right that banks don't fund startups without personal guarantees. (Been there. Done that.) But the capital markets are highly efficient and there's a reason that they're structured a certain way. (Please believe that I'm not arguing that there aren't better ways.) You might be able to give money to a company, but only a very deperate one. Any startup that can attract an angel round can do so without giving up control of the company at all.

Charles River has their new CRV QuickStart Seed Funding Program. You'll notice some fundimental differences in how the transaction takes place. Charles makes their terms very attractive, but of course they're looking to stay on for future rounds.

75 (or so) Venture Capitalists Blogs

The current list of 75 or so VC blogs:

 

• A VC - Musings of a VC in NYC (Fred Wilson, Flatiron Partners, Union Square Ventures)
• A Venture Forth (Dan Grossman, Venrock Associates)
• A little ludwig goes a long way (John Ludwig, Ignition Partners)
• Above the Crowd (Bill Gurley, Benchmark Capital)
• Adventurista (Sarah Travel, Bessemer Venture Partners)
• Allen's Blog (Allen Morgan, Mayfield)
• Ask the VC (Brad Feld, Mobius Venture Capital and Jason Mendelson, Foundry Group)
• BeyondVC (Ed Sim, Dawntreader Ventures)
• BijanBlog (Bijan Sabet, Spark Capital)
• Boston VC Blog (Jeff Bussgang, IDG Ventures)
• Burnham's Beat (Bill Burnham, Softbank Capital Partners)
• Christine.net (Christine Herron, Omidyar Network)
• Class V (Sachi Gahan, CenterPoint Ventures)
• Cleantech Investing (Rob Day, Expansion Capital Partners)
• Consuming Ambitions (Tom Cole, Trinity Ventures)
• Cracking the Code (Philippe Botteri, Bessemer Venture Partners)
• Dav-generated Content (David Dufresne, Desjardins Venture Capital)
• Deal Flow: Venture Capital Blog at BusinessWeek Online
• Deep Green Crystals (Martin Tobias, Ignition Partners)
• Due Diligence (Tim Oren, Pacifica Fund)
• EarlyStageVC (Peter Rip, Leapfrog Ventures)
• Ego Ventures (Andrew D. Luter, BaseCamp Capital)
• Feld Thoughts (Brad Feld, Mobius Venture Capital)
• Florida Venture Blog (Dan Rua, Inflexion Partners)
• Fred Destin's Blog (Fred Destin, Atlas Venture)
• From Istanbul To Sand Hill Road (Baris Karadogan, ComVentures)
• Geekfishing (Rich Tong, John Zagula, John Ludwig, Michelle Goldberg, Steve Hooper, and Adrian Smith, Ignition Partners)
• Genuine VC (David H. Beisel, Masthead Venture Partners)
• Global-Themes (Shantanu Bhagwat, Amadeus Capital Partners)
• Go Big or Go Home (Rob Schultz, IllinoisVENTURES)
• Infectious Greed (Paul Kedrosky, Ventures West)
• Israel Venture Capital 2.0 (Daniel Cohen, Gemini Israel Funds)
• John Cook's Venture Blog (John Cook, Seattle Post-Intelligencer)
• Let the Good Times Roll (Guy Kawasaki, Garage Technology Ventures)
• Let the Sparks Fly! (Mark Skapinker, Sophie Forest, Tony Davis, Brightspark Ventures)
• Life With Alacrity (Christopher Allen, Alacrity Ventures)
• Longworth Venture Partners Blog
• McInblog (Ryan McIntyre, Mobius Venture Capital)
• NW Venture Voice (Martin Tobias, Ignition Partners; Kevin Cable, Cascadia Capital; Dave Chen, OVP Partners; John Zagula, Ignition Partners; Rich Tong, Ignition Partners; Stephen Hall, Vulcan Capital)
• Nivi (Babak Nivi, Bessemer Venture Partners)
• Northwest VC (Steve Hall, Vulcan Capital)
• Nothing ventured, nothing gained (Jeremy Levine, Bessemer Venture Partners)
• Occam's Razor (Marc Goldberg, Occam Capital)
• Om Malik on Broadband (Om Malik, Business 2.0)
• Our Man in Nirvana (Robin Bordoli, Mobius Venture Capital)
• Oxyfish (Tom Shields, Woodside Fund)
• Pascalsview (Pascal Levensohn, Levensohn Venture Partners)
• Paulgraham.com (Paul Graham, Y Combinator)
• Permanent Record (Rob Hayes, First Round Capital)
• Punctuative! (Matt Winn, Chrysalis Ventures)
• Reality (Susan Wu, Charles River Ventures)
• Redeye VC (Josh Kopelman, First Round Capital)
• Ross Mayfield's Weblog (Ross Mayfield, Socialtext)
• SF Venture (Keith Benjamin, Levensohn Venture Partners)
• Salman's blog (Salman Farmanfarmaian, SCP Partners)
• Sense and Cents (George Zachary, Charles River Ventures)
• Six Kids and a Full Time Job (Michael Eisenberg, Benchmark Capital)
• Soaring on Ridgelift (Stu Phillips, Ridgelift Ventures)
• Software Only (Jeff Clavier, SoftTech VC)
• Southeast VC (Jason Caplain, Southern Capitol Ventures)
• Startups and angels: along the way to success (Tim Keane)
• TahoeVC (Robert Goldberg, Ridgelift Ventures)
• TechBytes (Jason Ball, London Seed Capital)
• Technofile Europe (Max Bleyleben, Kennet Partners)
• The Equity Kicker (Nic Brisbourne, Esprit Capital Partners)
• The Gong Show (Andrew Parker, Union Square Ventures)
• The J Curve (Steve Jurvetson, Draper Fisher Jurvetson)
• The New Normal (Roger McNamee, Elevation Partners)
• The Post Money Value (Rick Segal, J.L Albright Venture Partners)
• The vc in me.... (Raj Kapoor, Mayfield Fund)
• This is going to be big. I can feel it. (Charlie O'Donnell, Union Square Ventures)
• Treading the VC Waters (Sagi Rubin, Gemini Israel Funds)
• VC Adventure (Seth Levine, Mobius Venture Capital)
• VC Confidential (Matt McCall, Portage Venture Partners)
• VCMike's Blog (Mike Hirshland, Polaris Ventures)
• VCball (Steve Brotman, Silicon Alley Venture Partners)
• VCinJerusalem (Jacob Ner-David, Jerusalem Capital)
• Venture Again ( Justin Label, Bessemer Venture Partners)
• Venture Chronicles (Jeff Nolan, SAP Ventures)
• Venture Cyclist (Richard Dale, Sigma Partners)
• Venture Explorer (Vineet Buch, BlueRun Ventures)
• VentureBeat (Matt Marshall, Mercury News)
• VentureBlog (Andrew Anker, August Capital and Six Apart; David Hornik, August Capital; Kevin Laws, PacRim Venture Partners; Naval Ravikant, DotEdu Ventures; Martin Tobias, Ignition Partners)
• VentureInside (Kara Nortman, Battery Ventures)
• Ventureblogalist (Rob Finn, Edison Venture Fund)
• WayTooEarly (Howard Morgan, First Round Capital)
• Who Has Time For This? (David Cowan, Bessemer Venture Partners)
• Will Price Blog (Will Price, Hummer Winblad Venture Partners)

Venture Capital distribution

Venture capital: Silicon Valley and everyone else.

Silicon Valley receives more than twice as much venture capital as a share of its economy as does Seattle, the next-highest metro. This is clearly because the area remains the technological innovation capital of the globe, with a strong presence in a host of high-tech sectors, including biotech, Internet, telecom, computers, and devices. In contrast, other top-ranking metros, including Seattle, Austin, Raleigh-Durham, San Diego, and Washington, D.C., are much more specialized on one or two high-tech industries. The presence of strong university engineering and science programs, in places like Silicon Valley, Austin, and Raleigh, is also associated with venture capital investments.

		100th-76th Percentile
		75th-51st Percentile
		50th-26th Percentile
		25th-1st Percentile

First Round: Preferred Equity vs. Convertible Debt

From Feld Thoughts: Best structure for a Pre-VC Investment?

Assuming that you are planning on raising VC money some time in the future, there are two different typical structures for the first angel financing: (1) convertible debt and (2) preferred equity.

Convertible Debt: This is the easier approach of the two.  In this case, the investment is in the form of a promissory note that converts into equity on the terms of a “qualified financing” (where qualified financing typically is defined by having a minimum amount – say $1m of total investment.)  The note will either convert at a discount to the price of the qualified financing (usually in the 20% – 40% range), will have warrant coverage (usually in the 20% to 40% range), or both.  This discount and/or warrant coverage gives the angel investors some additional ownership in exchange for taking the early risk.  This note should be a real promissory note with the conversion and redemption characteristics clearly defined to protect both the investors and the entrepreneurs from any misunderstandings.

Preferred Equity: This is also known as a “light Series A” – it’s preferred stock that is similar to that a VC will get, but usually with lighter terms due to the relatively low valuation associated with it.  For a very young company, a $500k investment can receive between 25% and 50% of the equity in the company and, as a result, many of the terms associated with a typical VC investment are overkill.

From Redeye VC: Bridge Loans vs. Preferred Equity

an entrepreneur wants a seed-investor who can add real value, it is not productive to economically penalize that investor when they add it.  Structuring a seed-round as equity allows the investor and entrepreneur to be completely aligned and share one goal - to create as much value as possible for the company.  

National Venture Capital: Model Financing Documents

• Term Sheet
  
• Stock Purchase Agreement
  
• Certificate of Incorporation
  
• Investor Rights Agreement
  
• Voting Agreement
  
• Right of First Refusal and Co-Sale Agreement
  
• Management Rights Letter
  
• Indemnification Agreement

Startup Funding: The CRV QuickStart Seed Funding Program

From Charles River Funding: QuickStart Seed Funding

Charles River Funding (Boston & Silicon Valley) is launching a new program looking to move them down the food chain and get into companies while the gettin's good. Read the NY Times article: Venture Firm Is Giving Loans A Try. (registration required)

Here is how the loan works:

• A standard interest bearing loan will be made to a corporation, which we will help you establish if you do not already have one in place. This arrangement eliminates any personal liability for the loan.
  
  
• It is our intention to convert our debt into equity if and when your company closes its Series A round. If the company successfully raises its Series A, in exchange for sharing the risk with the entrepreneur, CRV receives a discount on the conversion price when the loan is rolled into the Series A. The discount will be a maximum of 25% (determined ratably at five percent per month, depending on how long it takes to create a Series A financing, up to the maximum).
  
  A simple example: if CRV loans your company $100,000 with a six percent interest rate, and six months later the company closed a Series A round, at that point the loan balance (with interest) would convert at a 25% discount (value = loan dollar amount plus interest / .75) into $137,333.33 worth of Series A stock. Given that seed funding amounts are typically very small compared to the amounts one might expect to raise in a Series A round, as the example illustrates, the aggregate discount amount, in this case $37K, is a tiny fraction of what is likely to be a multimillion dollar Series A financing.
  
  
• In addition, CRV would like the opportunity to support the Series A financing and thus retains an option to contribute up to 50 percent of your Series A funding. For example, if you raise a $3M Series A round, we can contribute up to $1.5M of the round.

Redeye VC thinks the move is to address exit trouble:

It also is a recognition of some of the challenges that larger venture funds face.  Take a hypothetical traditional $400M VC firm.  In order to achieve a 20% IRR, the fund must return 3x their initial capital over a 6 year term -- or $1.2B.  Now say this hypothetical VC firm typically owns 20% of their portfolio companies at exit (an industry average).  That means that at exit their portfolio needs to create $6 Billion dollars worth of market value (ie, $1.2B / 20%).  Assuming that their average investment size is $20M, that means that they invest in 20 companies -- this assumes an average exit valuation of $300M PER COMPANY.  Given the tight IPO Market and an average M&A exit value of less approximately $150M, this math creates some real challenges.

From VentureBeat

The advantage of a seed round is that it done as a “convertible” loan, which means the $250,000 is essentially a no-strings-attached loan to an entrepreneur. There is no equity stake claim by the investor at the time, which is good for the entrepreneur, who can see how good his idea is first. If the idea gains traction, he can raise money in the series A and negotiate a high valuation for his company. If he can command a $5 million valuation, for example, the investor’s $250,000 seed money converts into only 5 percent of the company.

Zachary  says he sees too many entrepreneurs giving away between 10 to 20 percent of their company in the seed round. They have fewer shares to give to employees, and they’re less attractive to venture capitalists.

There is almost no liability for the entrepreneurs, because the loan is made to a corporation formed around the entrepreneur. If the company fails, the company goes away, and the founders aren’t liable. “We’re all big boys,” says Tai, explaining that CRV doesn’t mind when this happens. “We go into this with eyes wide open.”

Fred Wilson of Union Square shares his analysis

I think that's a very fair deal. The loan is structured very similarly to what some angels are doing these days (loans that convert at a discount) and Charles River gets to take up to half of the round on the same terms as the other new investor.

Read the first bullet: There's also no personal liability. Something that Utah investors could take note of. 

Startups, venture, hiring, tech, geeks, & other smarts.

Paul Graham writes insightful essays on... 

• How to Start a Startup.
  Build something users love, and spend less than you make.
• Hiring is Obsolete.
  The market is a lot more discerning than any employer.
• How to Make Wealth.
  To get rich you need to get yourself in a situation with two things, measurement and leverage.
• Ideas for Startups.
  The initial idea is not a blueprint, but a question.
• Why Smart People Have Bad Ideas.
  A hacker who has learned what to make, and not just how to make, is extraordinarily powerful.
• The Hardest Lessons for Startups to Learn
  Some things about startups are kind of counterintuitive.
• How to Fund a Startup.
  Venture funding works like gears.
• How to Present to Investors.
  Explain what you're doing and why users will want it.
• The Venture Capital Squeeze.
  Why not let the founders have that first million, or at least half million?
• The Other Road Ahead.
  You may not believe it, but I promise you, Microsoft is scared of you.
• What Business Can Learn from Open Source.
  There may be more pain in your own company, but it won't hurt as much.
• What the Bubble Got Right.
  Even a small increase in the rate at which good ideas win would be a momentous change.
• A Unified Theory of VC Suckage.
  If you're not one of the very top funds, you're condemned to be the bad guys.
  

Founder Discount: More on why founders make less than hired guns.

From Canadianbusiness.com: Read the entire article here.

To solve the mystery of the underpaid entrepreneur, Wasserman collected data from 1,200 executives at more than 500 U.S. high-tech companies. After controlling for numerous variables such as experience and company size, his findings were stark: founders earn about $30,000 (U.S.) a year less than hired-gun managers doing pretty much the same job. In fact, 51% of founders earn less or the same as their employees.

The good news: the founder discount isn't forever. It shrinks over time and with the growth of the company. The bad news? Founders' compensation is inversely related to their control over the organization and their own job satisfaction. As I read it, as a company grows and gets more complicated — with more layers of management, boards of directors, outside investors and stricter management-performance metrics — founders get paid more because their jobs get harder.

But why does the gap exist in the first place? In simple terms, it's because founders tend to care too much about their own creations. Outside executives have to be paid market rates or more to join a company, and if their compensation doesn't keep pace with the outside world, they have little incentive to stay. Founders take a longer view. Like Cullen, they often put the company's financial needs ahead of their own. And their boards of directors don't worry that founders will bail out, because they know that founders are emotionally committed to the organization.

And there's this:

Paul Britton, a compensation consultant to businesses big and small, sees this problem again and again. The founding partner of Crossford Consulting in Toronto says there are two stupid reasons why entrepreneurs underpay themselves.

First, he says, some entrepreneurs think they can use their own lousy compensation as a lever when negotiating subordinates' pay. By pointing to their own pay packages, they think they can convince their employees to accept less, too. The problem, of course, is that your best people have lots of job options and know you have an ownership stake; it's generally only less valuable employees who will agree to work for below-market pay.

The other reason entrepreneurs underpay themselves is bad budgeting, says Britton. Instead of factoring in an appropriate salary for themselves ahead of time, founders will wait and see how much money the business makes over the year, and draw from that. When he asks groups of entrepreneurs if they have built a rate of return for themselves into their forecasts, Britton says only about one person in 20 will raise their hand.

RSS Feed List: Business, tech, entrepreneur, angel & VC RSS feeds.

Here is a partial list of the local business, entrepreneur, angel and VC RSS feeds that I subscribe to. Post your own list and link through the comments. Does anyone know how to export a list from Bloglines so that the links work?

Click to read more ...

Founder Frustrations Blog: From Harvard Business Schools Noam Wasserman

From Noam Wassermans "Founders Frustrations" Blog. Noam Wasserman is a professor in the Entrepreneurial Management unit at Harvard Business School.

Noam's blog is a great read for entrepreneurs looking to understand how to structure ownership in a startup or why investors think they're adding more value than the entrepreneurs running the business. Here's nifty chart.

Table 6: Entrepreneur Expectations
(traces the trend between the entrepreneur’s perception and expectation of
the value-add potential of the investor throughout the various funding stages)

Entrepreneur's perception of investor

 

If it's so great, why hasn't it already been built?

Matt Asay has a post on 'Self indulgence and Silicon Valley' that gave voice to a question that I've been asking myself about Nimble which is, 'if this idea's so damn good, why 'hasn't' anybody done it already. It's a common question that every entrepreneurs faced with all the time. (10 seconds into the elevator pitch is when the eyebrows start to arch.)  Why? Because there are insulators that prevent people, even really smart people, from having the information they need to make sense of the world. How else could you explain George Bush.

Kiva: Microloans for third world entrepreneurs.

Kiva is an organization that makes microloans to tiny businesses in the third world. The repayment rate is 97% according to the site. I'm using Kiva for our extended family project this year, something you might wish to think about.

If you're a blogger and you'd like to post a banner like the one above on your blog, here's the code: <SCRIPT type='text/javascript' src='http://www.kiva.org/banners/bannerBlock.php'></SCRIPT>

If you would like to loan to Maria or any other entrepreneurs please head to Kiva.org. 100% of your loan goes directly to the borrower and you can loan as little as $25. Why not get started as an international financier today? With repayment rates around 96% you don’t have much to lose but you do have many lives to change.

Barriers to imitation

Excellent post on 'Barriers to Imitation' from Early Stage VC.

From the post: So what do we really mean when we say what’s your barrier to entry?  I think what we mean is really the reciprocal. What’s everyone else’s obstacle to imitation?  Competitive imitation erodes your uniqueness as in Unique Sales Proposition. It raises the cost of differentiation and it gives the customer more perceived choices.   You have to spend more to stand out and get less market share for it.

Imitation comes in many forms. It can be a current claim, as is “we do the same thing.”  It can be a future promise, as in “we will have that feature, too.” Worst of all, it can be a rapid replica of your actual product.  It is the latter that most investors care about when they fear competitive “entry” or imitation.

Re-casting the question as obstacle rather than barrier also points to how to address the issue.  There is rarely a single obstacle that is so insurmountable as actually to be a barrier.  However, you can often outline a series of speed bumps that will slow down even the fastest fast follower.

Early stage VC Article: What’s everyone else’s obstacle to imitation?

What are Your Barriers to Entry? Post worth reading.

Note to VC: “Wake up.”

Via: Lone Ronin on the oddness of venture capital.

Of course, this number is meaningless. No one can really forecast this kind of return on an investment. No one can really say, "Yeah, given our business model and the way we're structuring this deal, I totally see a 10x multiple in two years."

 

I mean, one more time, seriously? Anyone who stands in a meeting and says, "You'll get back ten times what you put into this thing," is absolutely, completely, without exception, lying through their teeth or overly naive about business in general.