Wrote a not-so-organized entry about our investment process...

I thought it might be useful to describe the venture investing process in the context of the recent discussion about transparency. Firms have their own processes and some of the details may vary, but generally speaking, most VC's probably have a similar process. Also, I've only been doing this for three years. I've been an entrepreneur for about 10. I've learned a lot over the last three years and think I've become much better at venture investing, but still have a lot to learn...

First, the principles. Buy low/Sell high. Funds have some "life" of around 6 years where they need to "exit". The point is to buy shares of companies for a low price and be able to sell them to someone at a higher price before the end of the fund.

During the bubble, people often invested on the "greater fools theory" which was the theory that there was always someone more stupid than you and that as long as the hype continued, you could sell your shares for more money to the next more stupid guy. This is VERY dangerous way to invest and luckily doesn't make sense anymore.

Buy Low

1 - Understand the business better than anyone else so you can determine that there is less risk than others might perceive. This will allow you to buy at a higher price.

2 - Ask for a lower price because of the value that your firm will add to the business after the investment. The "smart money" story.

3 - Be first. Find the deal first, sign a "no shop" and get a letter of intent (LOI) signed quickly so an auction doesn't start jacking up the price. This is sometimes in the interest of the entrepreneur as well since the auction process is a long and tedious process that sometimes ends up burning out the business and doesn't always lead to ending up with the best investors. If the entrepreneur plans to continue to raise money, getting the highest price isn't as important as closing quickly with a good investor and building the business.

3 - Negotiate. Push to get better terms in negotiation. Negotiation always occurs at some level, but since both investors and entrepreneurs can always screw each other at any point, the relationship between the investor and entrepreneur is essential. In a buyout where there is no relationship after the transaction, it's easy to play hardball since you don't have to work together afterwards, but in venture investing hard negotiations can often lead bad blood, hurting the business and lowering value. The "tone" is often set by the entrepreneur and it's sometimes counter-productive to go in hard when it's not necessary. Having said that, some VC's are EXTREMELY tough. So, my advice here, know your opponent and don't be tougher than you have to, but be prepared to fight to protect your interests if you have to.

Sell High - The Exit

Exiting is always tough, especially if you like the company. It's important to have an "exit strategy". Is the company likely to be acquired? Is the company likely to go public? Who are the probably acquirers? Are there comparable acquisitions? What were the valuations? The exit scenario and the comparable acquisitions or IPO's and their valuations help you determine what sort of multiple on the invested money you might get out and when. This number and the probability of getting to such an exit determine the current valuation of the business. Valuation for big companies with steady cash flows is sort of mathematical, but for venture businesses where "the probability of such an exit" is such a squishy number, valuation is really more flexible and based more on comparable than on discounted cash flows.

Deal flow

Deal flow comes from many sources. My best deal flow comes from introductions. That's why I'm excited about LinkedIn. Introductions from people who value my time are generally filtered and recommended to me with information that helps me understand the "angle" quickly. I find that non-solicited pitches have a very low signal to noise ratio and I unfortunately have found very few deals this way. I find that blogging is a great way to meet people "in context" and reading the blog of a potential business partner is a great way to get to know them. This context is a great way to filter for quality, I think.

Another source of deals is other VC's. Some VC's want to hog a round and crowd out all of the other investors, but many VC's share deals for a variety of reasons. Sharing deals lets you share due diligence, management, expertise in building the business and risk. Usually there is a "lead VC" on any deal who takes responsibility for the due diligence, negotiation of the terms and most of the risk. In cases where we are brought into a deal by the lead VC, it's less likely I'm going to be blogging about it since we're probably locked up immediately by an NDA and I haven't gone through the discovery process.

It's important to note that since buy low/sell high is the key, not all deals are obvious. Great companies are often over-priced and don't make sense from an investment perspective. Sometimes really boring companies or companies doing very poorly can be great deals if there is an exit scenario where you know someone would pay a lot of money to buy your shares.

The single most important criteria for a good early-stage deal is the quality of the CEO and the team. Investing in technologies or "market opportunities" without a good CEO is a key to disaster. Having said that, you need core skills/assets, uniqueness, a real market opportunity and a business plan that makes sense. Finally, the valuation has to make sense.

Valuation

Valuation is based in part on the risk involved in the business. There are clear milestones that decrease the risk in any business. Risk usually decreases as each milestone is hit. A typical series of milestones might be: team on board, competitive analysis and due diligence of business plan done, technology developed and prototype shipped, first customer signed, cash flow break-even, evidence of geometric grown in revenues and a scalable business, buyer/IPO in sight. From the perspective of the entrepreneur, it's better to take the minimum amount of money necessary and raise money as risk starts to decrease since the entrepreneur can demand a higher valuation and be diluted less. The problem is, raising money takes time and energy away from the business so you want to minimize the number of times you have to raise money. Also, since there are fewer investors around these days, often new investors will dictate the valuation and terms and will "wash out" the earlier investors if the earlier investors are not able to participate in following round. Although the market seems to be stabilizing a bit, it's still very risky for a small fund like ours to invest in a company that might require a lot of additional money since we could be "washed out" by future investors.

Investment Committee

Most funds have some sort of investment committee. Different funds have different rules. Some require unanimous agreement by the members, some vote and require some sort of majority. Our committee consists of myself, our chairman Jun, Paul and Richard representing our investors and the deal team. We generally try to get a consensus.

The Process

Deal flow is tracked and we always have a pipeline of possible deals. Most early stages of the process involve someone taking a look at a proposal or trying to put together a deal based on a theory or a person we would like to work with. As the thesis of the business and structure of the deals start to take shape, the deal gets discussed a bit internally and we allocate resources for due diligence. We will usually try to sign some sort of "no shop" agreement with the company so that we feel comfortable spending money on due diligence without fear that someone will come in and take the deal away. The due diligence process can take a lot of time and can involve building the business together. As a deal structure starts to take shape and the investment becomes likely, we put together a "high-focus memo" for investment committee. It's basically a summary of the deal with a checklist of items. We also start working on the term sheet which is a list of negotiating points. We usually try to brief the investment committee on deals as they begin to take shape. Once the high-focus memo is done, we have an investment committee meeting. Often the group discusses additional due diligence items and possible alternative structures. Often a deal will cycle through investment committee several times until people feel comfortable with the deal. Once investment committee is comfortable with the company, valuation and structure, we sign the term sheet. The term sheet is usually a non-binding letter, but I have never signed a term sheet that we did not follow to the letter. After the term sheet is signed, the lawyers draft the agreements. There is usually another round of negotiations on legal issues that aren't covered in the term sheet. If the term sheet is done well, most of these issues are not major. Once the documents are done, we sign, fund and announce.

Terms

The terms in the term sheet usually reflect common practice in the VC community. These practices are always changing to reflect changes in the market or styles of investing.

Usually money is invested in convertible preferred shares. Convertible preferred shares are shares that get a return before the common share in the event of a liquidation or an acquisition. There is usually some sort of trigger for the preferred shares to convert into common stock such as an IPO or a valuation milestone. Convertible preferred shares allow investors to give a higher valuation to a company with no assets because it prevents the common shareholders from liquidating the company and running away with the money before building the business.

Often the legal fees for the transaction are charged to the investee with some sort of cap.

There is usually some sort of protection from dilution so that the company can't sell share for a lower price and dilute the investor easily. Having said that, if the company really needs money and the current investors aren't willing to put money in, the new investors can easily negotiate away such anti-dilution terms.

---

Having just written this entry, I realize that it's a kind of rambling entry. Since I'm not sure how interested people are going to be in this entry, I'm going to post it as is since I'm too lazy to edit it. If people find it interesting, I may go back and edit it and maybe put it in my wiki.

due diligence and VentureBlog are two good VC blogs.

13 Comments

Good stuff, Joi. I've been impressed with the willingness and transparency of folks like yourself, Tim, Andrew, Naval, David, Esther, and the other VC/angel/analyst bloggers out there. I would bet that your willingness to create and be part of a conversation around the internals of your business, your motivations, and your investment focus will help to bring in better, more qualified deals as well.

You inspire me to write up something talking about my experiences on the other side of the table, as an entrepreneur who has been through the VC cycle a few times. I already have a presentation called Rules For Entrepreneurs that I use as a basis for a 2 hour talk to university students. One of these days, I've got a few other things going on right now. I'll write it up in my copious spare time, I suppose... :-)

Dave

Where does it say:
- insist that you're not like other VCs
- throw parties as your marketing tool
- attend as many conferences as possible
- require your investments to make money
- help out anyway you can
- redefine the art of schmoozing

Hey Marc, don't give away all of my secrets! ;-)

The "insist that you're not like other VCs" is definitely a classic pickup line. hehe.

Dave,

I have been thinking of building an entrewiki, a wiki of resources and discussion on entreprenuership -- something we should all value.

There is something fantastic going on with VCs and entreprenuers having open discussions of practice. Perhaps channeling some of this into a lasting and self-organizing resource would serve us and others well.

This is a good entry. It's long, but at the same time it could be ten times as long!

One thing it was hard for me to accept as an entrepreneur was that the most money/highest valuation isn't always the best deal. Most folks (at least first-time entrepreneurs) won't know the value of a good reputation as a VC, so it's super-important to encourage potential investees to get references from previous investees (including some from when things didn't work out too well with the company itself).

Can you really get folks to sign no-shops? That seems like a pretty high-risk thing for an entrepreneur. (I suppose it's easier these days....)

No-shops are common and useful. They are usually pretty short and often involve some sort of break-up fee. If you can get to the term sheet quick enough you don't need one, but if you need to spend some time getting to the term sheet they make sense. I don't think they are high-risk necessarily. Again, if the entrepreneur is confident and wants to start an auction, of course the no-shop doesn't make sense, but if you've basically decided who you're working with, a no-shop can get you speed and break-up protection.

And to the person who was concerned about the buy low/sell high comment. Yes, it sounds bad, but you can't make money buying high and selling low. Many investors like to invest in "low-risk" companies. They buy high. Then, when the company starts to tank, they sell. This is the story of the Japanese real estate bubble and many people who invested in the bubble.

Of course, the best case is that you invest at a fair valuation, the company increases in value and you sell at a fair valuation which is much higher than when you invested. If you're a good investor you have helped create value which is reflected in the higher valuation.

The other point is that no matter how good a company is, if the valutation is too high, you don't make money investing.

They key to doing buy low/sell high is to understand the risk better than others. The fair price is calculated from a discount based on risk. If you can prove to yourself that people are overestimating the risk, a higher price will still be "low" to you.

"Convertible preferred shares allow investors to give a higher valuation to a company with no assets because it prevents the common shareholders from liquidating the company and running away with the money before building the business."

Sure, this is true as far as it goes. But convertible preferred is not just about ensuring that type of liquidation doesn't happen. It also matters a lot down the road, if things don't go well enough that the company IPOs or is bought out at a significant multiple of the initial valuation. In those cases, it ensures that the VC at least breaks even.

Of course, there is also participating preferred. It can often be negotiated away (if it is even proposed), but the entrepreneur needs to be very clear on what this is and how it will impact their payout if the company is sold for a small but respectable multiple of the initial valuation. If the company is a home run it matters much, much less.

Good point Bill. There are all kinds of additional terms that can be added. Participating preferred is when you get you money back first, then also get you share of the common stock distribution. Some times there is a dividend attached which is called a pick. For awhile I saw some term sheets with multiple preference, meaning that, for instance, the VC would get say 3X there money back before the common got any. I don't see these term sheets any more. As you say Bill, if the company does really well, it matters less, but it often matters. ;-)

The terms are part of the negotiations and change depending on valuation, and a variety of other points. You can negotiate almost anything into or out of the terms, the key is knowing what you really need to fight for and what is worth giving in on. A lot depends on you leverage as well as you preference on issues such as control.

Great article - rambling is best - a stream of consciousness that reads like an informal chat over coffee... much more accessible than some labored, polished power point that reads like watching paint dry. I guess every day language like this is known as "transparent" - I call it common sense. The VC's relationship with the entrepeneur can only evolve and mature to the next level with dialog such as this. Thank you for leading the charge.

Joi. Thanks for reminding me, I still have fond and comical memories of ex Mackinsey consultants and famous game creators in a battle of egos to find the perfect valuation that would please an investment commitee led by two ex investent bankers who looked a lot like twins ;-) Oh was it Term Sheets we were actually discussing?

Great article.

Can you give me some inputs on the exit process.

I am plannign a startup. I have only technical skills and i tested the idea on research scale. Now i need investment for more quality/performance testing and I need people to support me technically.

I am looking for all the investment from VC's from Computers to office establishment..

What is the typical process?

How much share(in percentage) should i give in that case to VC's?

Which is preferred way for exit from the entrepreneur point of view?

caprio
dude@codebusiness.com

Your process sucks! Where is the creativity? I'd rather accept 100.000 from my grandmother than 10.000.000 from you. You suck!

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