Investing In Venture, A Bit Like Buying A Great Bottle Of Wine

I have seen a lot of articles published recently on the rise of “enterprise” investing in venture.  It’s supposedly back en-vogue!  Social media is dead and enterprise and data are where all the investors are going.  Personally, I think this is ridiculous.  It points to what is exactly wrong with the common media coverage of the venture capital market.  What is the next trend?  Where is the money going?  What exits did best in 2012?  These are questions that don’t really have a lot of relevance to most investors. They are simply ways to quantify what is largely unquantifiable.  Sure, firms have returns, but these are established in 5-10 year increments, not 1-year increments.  A firm might have had a few exits this year and then none next year.  Measurement comes at the end of a fund life.  I know that’s hard for most investors to grasp, but this asset class is not like a hedge fund or for that matter, not much like Private Equity either.  Investing in venture is a bit like buying a great bottle of wine. You can pick the producer, region, even vintage, but when you open it can determine what the experience will be.  Funds invest for 2-4 years and then harvest for the next 5-7. A fund is typically 10 years for a reason; it can take this long to create the complete picture. Just like a good Bordeaux!

For large established firms, venture is and always will be a trend-following business; some are leaders, some are followers.  Some even try to influence trends with their investment philosophy, making bets across a sector to create markets.  They can afford to do so.  They have to put all that money somewhere! On the other hand, smaller, more regional or industry focused firms like Cava are very specific in what and where we invest.  Our approach has been very simple and aligned from day one; focus on pioneering businesses that have demonstrated some quantifiable customer success in the marketing solutions and software industry, and then be very active and help them grow, any way we can.  Simple as that.  We believe that the world of marketing is under assault and the companies that are leading the way will dominate the new norm when it settles. Our focus on Enterprise is not because it is trendy or more profitable or has a better chance for success.  It is simply because that is what we know best as operators and where we can help a company succeed. So instead of asking what the trend is or which firm ranked first in 2012 exits, ask the principals what they believe in, how they will accomplish it and where they are best poised for success.  Not so different than a company in that sense.  Bet on the team, their process and how they execute.

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Ask the VC: When To Jump From Angel to VC

The next question in our series of posts from my Startup America Q&A might just be the best question of the bunch.  “How do you know when it’s time to jump from seeking a large angel round to asking for venture capital?”

Wow, the magic question.  Though I’m not sure I have the magic answer.  This is one that founders have been wrestling with for decades.  What makes this more complex is the ever-changing options for financing that are available today that weren’t 5, 10 or 20 years ago.

Let’s go back and look at the ecosystem in the past. VC was really a club industry.  Funds were smaller, there were a lot fewer firms and the path to raising capital was pretty clear; self finance, get some angels, friends and family money, and then, when applicable, go right to venture.  The angel capital community was small and well known, and the small number of VCs made the process relatively black or white.  What changed?  The Internet bubble of the 90’s.

All of a sudden, there was a proliferation of angels, newly minted millionaires who could and did have an active financing strategy.  This created a wave of investment capital into companies. VC’s raised ever-larger sums of capital for their funds and corporate VC came back.  Still the process was clear, angels first, then VCs after proof of concept.  This lasted until the bubble burst.  Many of the VCs that were created then are now either not around or have raised substantially smaller funds.

Fast forward to today, we have angel, angel networks, crowdfunding, institutional seed funding, venture of all stripes, growth capital, strategic corporate capital, hedge funds, family offices doing direct deals, and hybrid funds like Cava doing special purpose funding on a deal by deal basis.  The point is there are plenty of choices and the lines between with whom and when you fund is blurred.

So the simple answer is, there is no answer.  The right question is “who are the right investors for my company?”  This is usually a combination of personality, industry, value add, luck and timing. But we could talk about that in a whole other post.

In case you missed the first three posts from Ask the VC:

Accelerators – Not All Are Created Equal

Top Three Slides In Your Pitch Deck

Price Caps and LLC vs. C Corp.

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Ask the VC: Question 3 on Price Caps and LLC vs. C Corp.

Continuing our “Ask the VC – Startup America” series after a bit of a blog hiatus (we have closed 3 deals in the last 3 months), this was a popular question that I still hear a lot:

“As a very young startup, with a validated concept and freshly built app, will raising from angels on convertible debt with a price cap hurt me?  Also, does it matter if we are an LLC or a C Corp?”

For the first question, the answer is no.  Raising an early convertible debt round will typically not hurt you in future fund raising endeavors.  This is a commonly used structure that many entrepreneurs use in the early stages.  The reasons are twofold; first it allows you and the investors to not have to set a valuation on the business at this stage when many of the early questions on customers/users, etc. are not answered.  Second, it is simple and cost effective to do and can measurably decrease the time needed to get a financing done.

On the valuation point, a convertible debt round can be beneficial for the founders and other employees in terms of potential early dilution.  If at the first equity round your valuation is higher than it would have been prior to the convert, then most times you will be a net winner.  With this being said, the angels also benefit by typically getting a discount on their conversion to the first equity round, effectively giving them a risk premium for financing at the early stage.  Because it’s pretty straightforward and usually pretty clean, it’s an easy structure to get done, doesn’t involve much legal advice (forms are readily available online) and is commonly used.

Now what about a Cap?  Caps (dollar amount thresholds that are used for the price conversion) are meant to protect everyone in case the valuation gets pricey at the first equity raise.  It also provides protection in the case the opposite comes true and the company can be financed, but only at an extremely unattractive valuation; instruments can be used to protect the founders equity from being over-diluted.  For those who take the early risk, they are betting that they will end up with a fair equity share when there is a conversion.  If the valuation gets really high, let’s say $50M-100M like we’ve seen recently with some Social Media companies, then the early angels may end up with a very small percentage of the equity, even with their discount – not very attractive considering they took all the risk.  Therefore, caps can be used to protect the investor downside on the ownership.  Keep in mind this can complicate the next round of financing, but can usually be worked through.

As far as an LLC vs. a C Corp, most equity financing done by VCs are into C Corps.  This doesn’t mean we won’t invest in an LLC (we just actually completed 2), but eventually those companies will need to be converted prior to an exit.  Seek legal advice here as there is a potential tax consequence associated with these structures you should be aware of.

In case you missed the first two posts from Ask the VC:

Accelerators – Not All Are Created Equal

Top Three Slides In Your Pitch Deck

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Top Three Slides In Your Pitch Deck

Continuing our series of entrepreneur driven questions from my “Ask the VC” session with Startup America Partnership, I thought this question was very appropriate, as I have heard it multiple times over the past few weeks.

Question:  “What is the single most important item in the Pitch Deck that VC’s pay attention to?”

As an early growth round investor, we might have a slightly different answer than Seed or Angel teams.  Instead of a single important item, I tend to focus on 3 slides.

First, what is the problem that you are trying to solve?  How big is it (addressable, not total size of market) and frankly, does anyone care?  To further clarify, are you trying to invent a problem for your solution or is it built from a real need from which you have unique experience.  You would be amazed how many great ideas we see that have no apparent problem attached to them.  Demand is driven from a need.  Supply driven solutions can be huge (almost all consumer driven internet applications), but there is also a high failure rate.

Second, where are you in your journey?  Do you have real traction, whether that is revenue, or customer acquisition in some other form (users, partners, etc.)  Again, ideas are great but meaningful measureable proof of traction is a must for us and many other institutional investors.

Lastly – the team.  Who are you?  Why are you uniquely qualified to be the source of inspiration, knowledge, talent acquisition and leadership in the industry?   Why is your team the best for convincing prospective clients and investors to support your execution capabilities?

Certainly not an exhaustive list, but definitely three things I want to leave with in every meeting.  Other things obviously include the product strategy, financial plan, use of funds, measurement objectives, marketing and support plan and others.   But if you don’t have these three slides tightly communicated in your deck – the rest may never see the light of day.

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Accelerators – Not All Are Created Equal

A few weeks ago, the terrific folks at  Startup America Partnership asked me to host an hour web conference called “Ask the VC”.  I had a great time answering questions on a wide variety of topics related to entrepreneurship, the current funding environment and how we look at companies during various stages of growth.  As I was speaking, I kept thinking that many of these questions would make great blog topics.  So, here is the first of, I hope, a string of topics driven by the entrepreneurs themselves.  However, if you read nothing else in this post, please join the Startup America program;  it costs you nothing and provides so much!

Question:  “Accelerators are very popular right now.  Admittedly, not all are created equal.  On average, is an investment from them at $20k, in exchange for 5-10% of the company, actually a good deal?  It seems like a low valuation opportunity for the investors, not the entrepreneurs”

This question is very relevant right now given the explosion in accelerators, incubators, and programs designed to foster innovation.  The simple answer is yes, they are worth it if you are able to get in a program that can accelerate your path to success.  Most of the programs are staffed by great entrepreneurs themselves, have venture and angel investors working with them directly, and provide access to tools, people, technology, space, services or a myriad of other things that can be extremely helpful at the earliest stages.

If I am correct, Techstars claims that the success rate for their graduates in securing funding is in the 70%+ range.  By any measure this is truly amazing and worth 5-10% alone.  With that said, if your company is more mature and has some existing traction, you need to think long and hard about the dilutive effect that the implied valuation might have (although many of these programs only take common stock, warrants or in some cases, a convertible note with some discount).

My advice is think about the types of groups that you are applying to, what they can bring to the table and whether your chance of success can be dramatically accelerated by the program.  If the answer is yes, take the deal.

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Venture Capital Vs. Private Equity, Setting It Straight

It has been fascinating to watch the 2012 Presidential campaign kick into high gear. I liken it to rubbernecking on the highway. While I am not making a political statement on this blog post, I think we need to have a discussion on the differences between Private Equity and Venture Capital, considering the frenzy around Mitt Romney and Bain Capital. It’s amazing to me how a lack of fundamental understanding of this concept has permeated its way into the campaign. I know I shouldn’t be surprised when the media doesn’t do basic research or homework to truly understand an issue. However, I am more agitated with the candidates themselves who regularly use phrases like vulture capital to describe Bain Capital and their strategy. This is not only completely incorrect, but misleading and hurtful to a company, person and industry that has done some truly great things. Let’s be clear, there is a major difference.

Venture Capital describes a class of investment that focuses on smaller, earlier stage companies. Our investment is virtually always for equity only and is never leveraged. We initially take Minority ownership positions to make sure the early team is properly motivated to build a high growth company and share in the financial success. We are backing entrepreneurs, their ideas and their ability to scale the business. Think of it in terms of rocket fuel. Many crash and burn, but the successful ones can be spectacular. The risk is higher, but offset by potential return. In the process, these investments can create many jobs, as early growth stage companies typically need to scale rapidly.

Private Equity is an asset class that Venture is technically part of, but is usually meant to describe the investment strategy. Private equity firms are typically acquiring majority or controlling positions in larger, more established companies. The larger deals use leverage to complete the transaction as many of these can be in the hundreds of millions or even billions of dollars. The firms then help to manage the newly acquired asset, often replacing top management, selling or divesting of underperforming assets and acquiring other strategic companies to build a more efficient and profitable entity. The goal is to then sell the company at a premium. When it is successful, the emerging company will be more successful, can provide a great opportunity for job growth and build shareholder wealth.

Both investment strategies are appropriate for certain investors and both can offer tremendous value and return as well as create jobs for the future.

Good investing.  Comments always welcome.

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Getting Connecticut Back to Work, Part II

In Part I of my blog post “Getting Connecticut Back To Work”, I recommend increasing access to venture capital and angel financing as a way to support CT’s growth and job creation in the tech space.

Another strategy to encourage state growth is to stimulate and develop new funds or entities and other sources of capital financing.

One option is to cultivate the number of private and public sources of capital, in addition to the work done by Connecticut Innovations (CI).  CEOs of major Connecticut companies could be encouraged to allocate funds, either directly by such companies or by their pension funds, to one or more new Connecticut venture funds.  This can be coupled with tax incentives or credits, not unlike the existing Insurance Tax Credit program.  An important part of the message is that all stakeholders in Connecticut must work to reinvigorate the state’s economy, thereby enhancing the overall entrepreneurial environment.  Connecticut businesses, be they multinational or local, should support this effort.  In addition, it is time to start encouraging the pension funds to think CT first. While these funds have private equity allocations and even some later stage venture, a very small amount is actually in CT based early stage venture; the point at which many growth businesses are being created.  The growth of venture and other sources of capital will compliment the efforts of CI directly.

Another option is to create a state SBA program similar in scope to the federal level program with matching funds for state allocated investments. Matching at 1:1 or 2:1 is acceptable. The federal program has been successful in the past and has created several new firms in the process. At Cava, we are on the ground, finding great companies and working with their management teams to execute their vision. A state program could be very effective in drawing funds to the area, enticing more companies to build their futures here with the increased access to capital.

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