VI

From a new report by Deloitte.

We briefly scratched the surface of the dozens of potential terms that could be included in a  term sheet, but I wanted to emphasise a few points from our discussions.

1. In most cases the “terms” in a term sheet (or more accurately in the Investor Agreement – which is the legal document) are not *law* but contractual conditions that become binding upon successful completion of the agreement. As such, the writer of the terms can ask for anything they want.  Just because a clause in the agreement is titled “Liquidation Preferences” doesn’t mean that is “boilerplate” and there’s not some little twist in there that make its different than you expect.  Golden rule – always read the fine print!!!  And if you don’t understand the fine print, or sometime, even if you think you understand the fine print, ask an attorney.

2. Terms in term sheets are like vestiges of DNA – they served a very important purpose at some stage, under some set of conditions, or as a result of some catastrophic event, and are just carried along  – “in case”.  The result is two-fold.  (a) Terms sheets always seem to get bulkier and (b) just because there’s something in a term sheet that looks horrible, doesn’t mean that you can’t negotiate it away, or down to more agreeable term.

3. Terms can be fundamental or fads, depending upon the economic climate, legal situation or political temperature.  As many of you are aware, there is very contentuous but very real legistlation on the books that would treat VC carried interest as ordinary income verses capital gains.  That has the potential of having a real impact on VC  net income, so – even though I have no idea what – I’m expecting significant chance in terms to “compensate”.

Finally, one of the reasons for spending a whole session on one or two of the elements in terms sheet was to get you all to be become smartreprenurs.  The challenge is that you get involved with two possibly three or four term sheets in you lifetimes.  I’ve seen probably twenty.  One of the values of @StartVI is the aggregationof deal experience and the accumulation of specific knowledge that will help individuals.  So?  Start asking questions and sharing issues?  It’s the “consequences” of terms that you need to be wrapping your heads around, not the specific interpretation.  As we discussed on Wednesday, the financial impact of Liquidation Preferences can be negotiated for a better valuation.  If someone is asking for high multiples of  Liquidation Preferences *and* a low valuation, either they don’t know how it works, or they do and they’re counting on the fact that *you* don’t.

Next week @Start\UP bootcamp, we’re going to be looking at strategies and plans for getting investment. Of course, a significant proportion of that will be what VC’s are looking for in a company and business opportunity, but equally, we will be covering what a company should look for in a VC. In most cases I preface the following comments with “if you have a choice”, but “if you have a choice in which VC to take investment from” then it’s important to do as much due diligence on the VC as they will do on you. A relationship with a VC if like a marriage, except its usually easier to get out of a marriage!
I strongly recommend that startups dive into the VC’s web site. It’ll give the “nut’s and bolts” – things like investment philosophy, industry/sector focus, stage and typically round size. It’ll have a list of active and past portfolio companies, and usually the resumes/CV’s of the partners.

But that’s all the “selling side” of the VC. It’s best to dig into the “buying side”. What do founders in the portfolio company think, was it a good, bad or ugly experience. Are there biases, preferences? Landmines to avoid?
There’s a interesting “reputation” web site – www.thefunded.com – that provides a vehicle for anonymous feedback from founders, both those that were funded and those that were rejected. Typically, it’s usually the dis-satisfied that are the most vocal, and this site has had its fair share of “VC arm twisting” to get their reps up. But it DOES have feedback on a number of Irish and Northern Irish funds (Crescent Capital, Enterprise Equity (Irl and NI), ACT, QUBIS). There may be some value in the comments.
In the interest of help startups make a decision “if they have a choice”, I’m looking to start a “form guide” on Irish and Northern Irish VC’s, something a little more objective that typically “bitching”. I’m looking for considered feedback for anyone who has experience with (good or bad) any VC on the island.
Here’s my initial thoughts on the questions I look for opinions on
(all answers on usual scale 1-5, 1 is low/bad, 5 is high/good)
1. How responsive were they? (Returning calls)
2. Did they respond when they said they would?
3. Did they make decisions quickly?
4. Do they have operational experience (P&L) to offer?
5. Have they been part of a startup?
6. Have they had an executive position in a multi-national corporate?
7. Have they invested their own money?
8. Did they inspire confidence that they could add value to your startup?
9. Did they encourage or discourage you?
10. Would you take them for a drink, socially?
Please let me know if the answers to these questions would help budding entrepreneurs evaluate VC’s – “if you have the choice”.

There was very lively discussion tonight at @startvi on the, seemingly, blind requirement, for startup software companies to have patents. Rather that repeat the discussion here, let me summarize.
Patents do almost nothing for software startups, and do a lot of actual harm via the opportunity cost (in time and money) to gain an illusion of “defensible IP”.
Anyone requiring that a software startup has, or applies for, a patent earlier than one year before their anticipated exit either (a) doesn’t know software, (b) doesn’t know the software business or (c) doesn’t know the investment business.

(Title idea stolen for @cimota blog)

I was attracted to a post over the weekend from Steve Blank. In particular, this caught my eye … “business plans are a poor planning and execution tool for startups”.

I agree 100%.

I also agree with much of Steve’s reasoning, but not all. Without being repetitive, I thought I’d summarize Steve’s points, and add my own opinion.

Steve states that Business Plans (my caps added for reasons that will become obvious below) are for big, mature companies and not for startups.

Yes! Yes! Yes!

My first introduction to Business Plans was in the late 70’s, working for an international mainframe manufacturer, and rolling out a new product line in EMEA. This was a detailed product launch plan, that – mostly because it was in vogue – we called a Business Plan. Well it DID have demands forecasts, pricing, manufacturing costs, gross margins, sales projections, P&L and cash flows. But it ALSO had very detailed plans for every organization in the company that needed to do anything to launch the product; the particular part numbers assigned, configuration models, BOM, shipping instructions, warranty, support tools, contract additions, sales training, collateral, and commission plans – the whole enchilada. It was an “everything you need to do to launch a product” and if you were a product line manager – as I was then – it WAS your business.

Another quote from Steve’s blog – “A business plan is the execution document that large companies write when planning product-line extensions where customer, market and product features are known. The plan describes the execution strategy …”

Yes! Yes!

And my final quote – “In the early days of venture capital, investors and entrepreneurs were familiar with the format of business plans from large companies and adopted it for startups. Without much thought it has been used ever since.”

Yes!

It is urban myth that those with no real experience of starting a startup blindly promulgate as the basis for entrepreneurship and a key element of success.

This is where I digress from Steve’s reasoning, and rather than step through his, I’ll lay down my opinion.

First, without a business plan your idea will (most likely) fail. I don’t mean a Business Plan, I mean a plan for you business … it’s not an execution document. It a plan of what your business will do and why it will do that , not how it will do it – or at least not to the actual execution detail. It can be written in 10 pages with approximately 2,000 words. Its goal is to describe the strategy, not the tactics.

Second, its goal is to get investment – OK that’s a simplification, but serves the points that follow. What does an investor look for? A hot product, in a big market, with a team that can deliver, and where they can make money. If you can’t describe that in 2,000 or less then you don’t understand your business (paraphrasing Einstein).

Third. Don’t sweat the small stuff. I’ve seen Business Plans from companies that didn’t have a product yet, but knew how much they were going to spend next year on office supplies! That’s called “majoring in minors”. And you’d probably be surprised by what I consider “small stuff”. As a rule of thumb, I’m not interested in seeing any expense item that is less than 10% of revenue.

Finally. You DO need an execution document. It’s called an Operations Plan. It will describe very facet of your business operations; the product development plan, the support plan, the maintenance, the operations plan, the manufacturing plan, the marketing plan, the sales plan, the HR plan. It’s something you review every month – if you’re a startup. It’s how your startup operates, but it’s not a Business Plan.

This was a question asked by “Rutherford” earlier this week. This is an interesting subject that needs its own post.
The context of the quest was in respect to “they spin a new dynamic around the product concept, it gets traction and suddenly people are ‘getting it’.”
Firstly, I don’t think that it’s given that Silicon Valley always “gets it”. Many VC’s passed on Google, FB and Twitter. And some have jumped into the Google, FB and Twitter wannabes like lemmings. And journos in SV are much the same as elsewhere; their job is to provide “perspective” or “opinion”.
Don’t take away the impression that Silicon Valley can do no wrong. There are hundreds of screw ups, lots of bets lost on stupid products, and miles of copy written about dumb ideas. It’s just that one doesn’t dwells on them, or treat a mistake as a failure. People here are willing to try new things quickly, and dump them just as quickly if they don’t work out. And then switch to the next new thing. Look at the recent iPad launch; it would be interesting to compare the miles of favorable copy verses negative copy written on it. In the end its just opinion and we – all of us – get to decide whose opinion we agree with.
It also helps that we, here, are lucky to be exposed to new stuff all the time. Checkout an interesting location based iPhone app called Stalqer. I only learned about it when I was introduced to the founder/developer in a bar two months ago. It’s handy when you live less than a block from Twitter headquarters.
Now take everything that that’s a positive for Silicon Valley, and ask yourself – “how dies that compare to Northern Ireland?”.
I hope that answers the question you asked

One of the challenges in only having three hours per session, is that, to cover all of a subject, you need 2 or three sessions. Last week, we looked at Cap Tables and Dilution, and last night we looked at VC arithmetic. Next week we’ll pull it all together with investments and valuations. But, being the smart little buggers you all are, some of the questions last night could only be answered after we had all these elements in place.
I thought it may be helpful to summarize some of that discussion and make sure we’re well structured to nail this in the next session (or two).
Thus far we talked about ownership (and dilution) in terms of number of shares owned as a percentage of number of shares issued (not share authorized). But, it’s a very small step to turn ownership into a percentage of company VALUE. Simply take the number of shares and multiply by share price. Either is perfectly fine, and both will come to the same answer, but monetary value (i.e. shares * share price) is what you will be dealing with when you get into negotiation with a VC (or angel), or even looking at the value of public companies.
These two characterizations are identical.
If you own 200,000 shares out of 200,000 shares issued, you have 100% ownership. If you then sell another 100,000 shares for £20,000 you now have 200,000 shares out of 300,000 issued, which is 67% ownership, i.e. you were diluted by 33%.
Another way to say that is: if you are selling 100,000 shares for £20,000, then the share price is 20p (£20,000/100,000). At a share price of 20p, the company is worth (i.e. valued at) £40,000 (200,000 shared issued * 20p). You just increased the worth( Value) of your company by the money you got in from the investment (£20,000) so its NOW worth £60,000. Since you own £40,000 (your 200,000 shares at 20p) of this company valued at £60,000, you now have 67% ownership, i.e. you were diluted by 33%.
Eureka!
And, BTW, we’ve just covered pre-money valuation, money-in, and post-money valuation. But we’ll go into it for real next week.

StartVI is just about ready to take applications. We’ll be making this as simple and transparent as possible. Everyone will know the criteria and everyone will know very quickly whether they accepted or not. And if not, then why.

So, what we are looking for are companies:

- with a big idea (hot product)
- in a big market (that will sell millions)
- and make money all around.

Business plan is NOT required. You tell your story, we think we can figure out very quickly if it’s a big opportunity.

All other details are being covered on the Start\UP bootcamp.

When you take an investment in your company, generally you are selling shares for an agreed (and negotiated) price.  In general you take  £x for y shares, and by simple arithmetic you can see that you’ve sold the shares each for £x/y per share.  That deceptively simple calculation has some very interesting consequences, based on how things had been setup at registration time.

Consider two companies.

Company A has issued 200,000 shares and Company B has issued 2 shares.  In both cases they are seeking £100,000 investment.  All that is needed is to decide either the number of shares that they will sell, or the share price and that will determine the number of shares they will sell for the investment.

Company B has a real challenge.  Each founder owns 50% of the company – each has 1 share of the 2 issued.  If they sell another share, the number issued is now 3, and their ownership is diluted to 33% (each now only has 1 share of the 3 issued.)  And the share price is now £100,000 per share.  By the same logic, if they sell two shares for the £100,000 they have diluted to 25% (each now has 1 share of the 4 issued).  But at least the share price is down to £50,000 per share!  The more shares you issue the more you get diluted.

On the other hand, Company A has a lot more flexibility.  They can sell 25,000 shares for £100,000 – making the share price £4 per share.  But now the dilution looks a lot different.  Before this investment they each owned 100,000 of the 200,000 shared issued – 50%.  But after the transaction they each own 100,000 of the 225,000 issued, or approximatekt 44%.

That littlest of things at registration, cost the founders 22% of equity.

The Start\UP Brief: StartUps and Shares, covered those elements of shares that needed to be decided at registration. The implication of those decisions comes into play when you are looking for investment. If you never, ever, ever plan on seeking outside investment – from friends and family, angel investors or VC’s – you’re done. But just in case, you may want to keep reading.

Investing is basically selling part of your business in exchange for cash.  So you sell a number of shares in your business for a negotiated sum of money.  By the way, this is basically true for private companies and public companies – the difference being that when a private company “goes public” it offers it shares for sell with an “Initial Public Offering” or IPO.

Another couple of points regarding shares and share prices. If I own 100 shares in a company @ £1 per share, I have £100 of worth of stock in the company. I’d also have £100 of stock in a company if I had 1,000 shares @ 10p or 10 shares @ £10.  The only real difference is share price.

Some companies, both public and private, like to “manage” their share price. Too big a share price creates an impression of “too expensive”. And in fact can keep small investors from buying.  A extreme example of this is the share price for Berkshire Hathaway (Warren Buffet’s company). Last I looked it was $100,000+ per share. That keeps a lot if folks out!!!

But coincidentally, too small a share price creates a image of #fail. Penny stocks, those that trade at less than $1 are considered “distressed”.

So to “manage” share price, companies can choose to “split” their stock on occasions when they wish to have a smaller share price. A typical ”2 for 1 split” basically gives the shareholders two shares for every one they currently own, for half the price.  A stock that was trading at £50 would be split into two, each at £25.  In general an n for m split creates n/m shares at m/n the price.

Similarly a “reverse split” can be implemented to create a higher price per share. A 10 to 1 reverse split will take ten of your shares and give to one back, at ten times the price.

The purpose of this discussion on splits?  Simply, if you’ve already registered a company and ended up with too big, or too small, a share price, a split can adjust it.