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Too Much of a Good Thing? Sizing your B Round.


Many have raised alarms about the significant shortage of early stage capital in the venture industry and, as Nate wrote recently, the Federal government is riding to the rescue with a proposed $2B funding mechanism.  Whatever one might think of the risks and benefits of the Federal bond program, it is an apparent recognition of problems in the angel and A round communities, problems which we impliedly cannot ourselves solve.  There is some question in my mind as to whether there is, in fact, a shortage.  After several years of severe over-funding, and now two plus years of market correction, it might be too soon to know if the current level of funding is too low or just about right (I am speaking now not about job creation, of course, but about funding levels to support sustainable economic returns).   Many of the ideas we see and fund do not require large amounts of capital, and certainly nothing like the capital required by the successive huge venture waves relating to telecom, wireless infrastructure and the internet land grab.  It is quite possible that the available capital is not too far from the right amount.  That said, there are extraneous forces that have made fundraising extraordinarily difficult, and in an environment where liquidity is king, raising early stage venture money, with its long maturity cycle, is nearly impossible.


We can, however, safely assume that the A sector is significantly underfunded relative to later stage funds.  This imbalance has led to some interesting market dynamics which pose challenges for our companies and for A investors.  These challenges are particularly acute in the enterprise software companies in which we invest, which tend to have modest lifetime capital requirements.  We now see a common pattern.  Early stage companies that break from the pack and show meaningful promise are inundated with later stage investment offers, offers which almost uniformly proffer two to three times the amount of capital identified as needed by the company.  The amount of capital, in other words, is driven by fund economics, not company requirements.  One might think that the offer of so much unnecessary capital would be ignored as too dilutive by the target managers.  But these large offers are feeding a second trend that has become prevalent in the last few years.  More and more founders want to cash in a portion of their chips early.  The result is a spate of later stage funds offering to invest capital in the company while buying a portion of founders’ shares.  A perfect solution – the company is not overfunded, and the founders achieve partial liquidity.


Unfortunately, the solution is rarely perfect.  We are not at all opposed to founders and early investors (sometimes even us!) achieving partial liquidity in appropriate circumstances; often times this further aligns the interests of the investors and entrepreneur, particularly with respect to the timing of exit.  But there are real costs to closing on a large later stage round that need to be carefully evaluated.    


Here are the primary concerns we discuss with our boards and managers:


  • Higher valuations plus large investments for new investors equate to a higher required valuation for exit.  Assume the founders own 30% of the company after raising $3-5m of early stage capital.  At a $50m exit, the founders will take home $15m, and the investors will have achieved a roughly 7x return, a great result for all.  If that same company raises $15m at a $45m pre-money valuation, the new investor (who now owns 25% of the company, assuming no founders’ shares were purchased) will look for two outcomes. 


  1. Outcome one:  On the upside, a 5x or better return would be targeted.  Taking the low end of the range, a 5x return to the new investor requires a sale of the company at $300m.  This means that the company will have to ramp up its spend and its burn and, ultimately, assume much greater risk to meet its revised goals.   This might be wholly appropriate for many great companies, but it is not for all.  The point is, that taking more capital than is clearly needed can mean taking on more risk, not less.
  2. Outcome two:  On the downside the new investor might insist on a 2x or 3x liquidation preference to justify the high valuation.  With a 2x liquidation preference, the first $30m of proceeds goes to the new investor, and the $50m exit is now worth $6m to the founders.  The break-even point for the entrepreneur is a sale of the company at $80m; at that point, the new investor gets $30m to satisfy the 2x preference, and the entrepreneur gets the $15m referred to above.  The new investors request is not unreasonable.  My point is that, again, risks have gone up for the pre-existing investors. [Note – these numbers all shift to some extent is the buyout includes the purchase of some insiders’ stock].


  • When the company clearly is going to need the larger amount of capital over some period of time, then we remind ourselves that the world is a fickle place and that it takes a very brave investor/board member to turn down ready money on reasonable terms.  In this case the discussion is really about dilution.  If we are extraordinarily bullish on the company’s prospects, should we take just what we need now and raise funds at a much higher valuation a year from now?  We try to distinguish between the bullish and bull here.  If the next 12 months revenues are already booked, or major new relationships are inked that will drive those revenues, there may be reason to be bullish.  But if it is a matter of extrapolating a positive growth line from the last six or eight quarters, well, we don’t mind a little dilution.  Most companies have a major hiccup or two along the way, and if we haven’t had one in the last two years we might just be due.  In other words, if there is a use of proceeds during the next 24 months (instead of the usual 12-18) that justifies the larger investment amount, we are often amenable.  It does not pay to be greedy.


  • On the other hand, what do we do if the company does not really have a need for the capital, or in any event can’t identify the need without a fair amount of creative thought.  We know that a company’s goals and expenses inevitably expand to match resources.  We worry when the driver is founder liquidity and not company needs.  Our comfortable pattern is reversed.  We like it when (a) a company defines goals and therefore capital requirements and (b) it raises the capital.  We get very nervous when (a) capital finds a company and (b) the company defines its goals to use the capital.  In this circumstance, and particularly with the extra motivation of a partial liquidity event, most managers have no trouble coming up with marketing opportunities, new product extensions and target acquisitions that justify the large capital infusion.  We do not oppose the liquidity event for the managers, but we are very reluctant to overfund a company to achieve an otherwise acceptable goal.


  • These conversations are sensitive and require an honest reckoning with our managers, including a recognition that our interests may be inherently in conflict.  As investors without short-term liquidity requirements, we are better off if the company raises no more than it needs and the founders give up on a near term liquidity event.  We are rarely sellers ourselves in these circumstances, and although we welcome later round investors for both their capital and their wisdom, their need to get so much capital to work often re-risks a company we had put in the clear “win” category.  Thus, we usually push the new investor to lower the minimum capital they have to invest.  The conflict is exacerbated by the fact that we often want to invest further dollars in our best companies, which either drives up the size of the round or pressures the outside investor to invest even less.


  • Finally, we are quite sensitive to the new investor’s long term appetite for investing in the company.  Often the new investor hopes to have a significant follow-on round, which creates the exact same dynamic again with even more potential for complexity and conflict around the boardroom.


Note that I have not mentioned valuation at all.  The best companies are not only being offered more capital than they need, but also at valuations that are relatively rich.  Dilution is not really the issue here.


During my first 10-15 years in the venture business, it was largely a given that you did not want your entrepreneurs to sell any of their shares prior to a shared exit event.  That rule eroded over time, for a variety of reasons, and partial liquidity has become almost commonplace.  It is helpful to have a conversation prior to investing with managers about their expectations and needs with respect to shorter term liquidity.  In truth, these expectations and needs evolve over time, and the conversation will accordingly evolve.  However, even if striking the right balance cannot be done in advance, it is helpful to agree what should be on both sides of the scale.



HIMSS 2011 Conference – early data on Regional Extension Centers 

I attended the HIMSS (Health Information and Management Systems Society) Conference a couple weeks ago in Orlando.  It is the main healthcare IT conference of the year, and this year’s event had over 31,000 attendees (breaking the previous attendance record) and over 1,000 exhibiting companies and societies.  It was held at the Orange County Convention Center (the rumor at the conference was that it is one of only three places in the US that is big enough to host the conference).

RECs (Regional Extension Centers) were one of the hot topics at this year’s conference.  The mission of the RECs is to help physicians achieve meaningful use with EHRs (Electronic Health Records).  RECs are funded through the HITECH Act and were first created about 12 months ago.  Farzad Mostashari participated on a panel about ARRA and meaningful use.  In addition to winning the Longest Title Award (Deputy National Coordinator for Programs and Policy, Office of the National Coordinator for Health Information Technology), he relayed some interesting statistics:  in less than 12 months, 62 RECs have enrolled 46k providers who care for 70M patients.  I was pleasantly surprised by these stats; sure, enrolling a physician is a lot different than a physician achieving meaningful use (and Farzad did not provide statistics on how many of the 46k providers have achieved meaningful use), but it’s a good start.  Hopefully this encouraging initial traction in enrollments translates to success throughout the process. 

Certainly the different RECs have varied levels of effectiveness, and people in healthcare have mixed reviews of their performance to date.  But hopefully there are enough RECs providing the type of practical, hands-on and operational assistance that physicians need to make the program a success.  And as physicians achieve meaningful use, they will drive more needs (and investment opportunities) in areas such as interoperability, data extraction, and business intelligence, etc.  As patients and investors, we are rooting for RECs.  


What's your exit?

Entrepreneurs have usually developed stock answers for most standard VC questions by the time they meet with us.  We typically wait until the end of a pitch to pose one deceptively tough one – “What is your goal on exit?”

As I have said before, everyone on our side of the table has read everything that the entrepreneur has provided, so we rarely spend much time on the prepared pitch deck.  Instead, we go right to Q&A.  Needless to say, most of our discussion educates us, to the extent possible, about the technology/business to be funded.  That is the body, so to speak, of the essay.  However, we still have an introduction and a conclusion to contend with.  

For us, the introduction is the most important and interesting part of most first meetings.  This is when we ask the entrepreneur to tell us about him or herself.   This answer (depending on the number of managers present, and the nature and depth of their experiences) can take 10-30 minutes, by the time we are done exhausting our curiosity.  These interactions are, from our part, entirely unscripted and often lead to unexpected insights.  If the entrepreneur is experienced, we tend to dig into lessons learned, particularly lessons learned the hard way.  If the entrepreneur is a first timer or otherwise relatively inexperienced, we like to understand how deep the entrepreneurial current flows, and sometimes find ourselves learning about high school start-ups, family business backgrounds or other first signs of a restless spirit.  We avoid dime store psychoanalysis, but we pay close attention during this time (and throughout, but first impressions are everything!) to self-awareness, an ability to listen as well as communicate, large ego indicators (managers whose career never benefited from luck, help and/or good colleagues) and small ego indicators (managers who encourage their subordinates to share in the presentation), manager interaction and interpersonal chemistry. 

The conclusion is frequently framed by three questions.   One is “how much are you raising (now and in the future) and what is the use of proceeds?”  The second is “what valuation are you seeking?”   There is much to be said about these topics, but that will be for another blog.  The final question is “What do you see as the exit here?”  And that is a much trickier question that it appears. 

This is one of those questions to which there are many wrong answers that can undermine a strong presentation but no right ones that will save a poor presentation.    As a result, it is also the question that entrepreneurs work hardest to figure out what we want to hear rather than what they want us to understand.   This may be because the question has a particular subtext that we should probably make explicit.  When we ask about exit, we are really trying to understand if we are aligned in our thinking. 

Here are some of the issues we are thinking about when we ask the exit question:

  1.  Do the management’s aspirations match the company’s realistic potential?  It does not help to have a $500m CEO running a $100m opportunity, nor does it help to have a $25m CEO running a $200m opportunity.   In the former case, the company will be over-funded and over-built and returns will be crushed.  In the latter case, the company will under hire, both in talent and in numbers, and will jump at an early offer when the dance is just starting to get interesting.
  2. Is the fat part of the exit bell curve, as identified by the entrepreneur, sufficient to give us the return we need while making the entrepreneur wealthy? 
  3. Are the exit scenarios well known or do they require novel mechanisms or new players?  For example, is the expected exit a trade sale into a sector with multiple active acquirers, who historically pay a fair price, or does the exit depend on the appearance of new and surprising players, like hedge fund migration into PE or China- or India-based acquirers?
  4. How does the idea of an IPO get framed?  The IPO as an exit remains deeply alluring, and almost completely remote, when one is raising first time institutional capital.  If the entrepreneur wants to put the idea of an IPO on the table, it should be with clear and realistic benchmarks of what the company needs to achieve to consider the public markets.
  5. Does the entrepreneur have a “personal number” that is consistent with the desired range of outcomes?

My suggestion is to aim for the fattest part of the fairway.  If I were the entrepreneur, I would tie exit valuations to the date of the sale, pointing out that if the company hits its revenues its value will be here in four years and there in six years.  I would use trade sale multiples as my benchmark, pointing out than an IPO or a competitive, high-multiple exit are possible and can and will be made as likely as possible, but are not worth deep consideration at this early stage.    I would say that I am in it for the money, and that means I would sell early only if the offer was exceptional relative to the company’s ongoing assessment of its risk.  I would ask the investor’s time horizon, and how many years the fund partnership has left, to be sure the investor can be patient.  Most of all, I would say that I expect to make money by building a great company and letting the exit take care of itself.


Board to Tears

I have been on enough Boards now to appreciate how unique each board experience is and how critical board composition and chemistry is to a company’s success.

My experience at this point has run the gamut.  I have been on boards that brought on “smart” money, some times to the regret of all and other times to great effect.  I have been on boards that brought on “dumb” money, always to the regret of all.  I have joined boards representing the smart money and have, I suspect, occasionally represented the dumb money as well.  I have been the board heavy and the management ally; the dissident and the unifier; the catalyst for management change and the last person to agree that change is necessary.  Since my approach has been generally consistent over the years, the wide variance in my experiences suggests that our boards define us as much as we define them.

At one point in my career I was on two boards and had reached the point where I was adding value to neither.  At one company, a significant underperformer, management had grown tired of my criticisms and had, essentially, written off both my advice and the prospect of our future support.  We fell into a familiar trough – one in which the VC waits for the company to need  money again so that change can be forced, while the company tries to bring in outside money and dares the VC to assert any rights in the face of ready money.   At the second company, a kick-ass of a performer, management had simply outstripped the boards and my ability to add insight, relationships or knowledge beyond relatively minor mirroring work (management tries on an idea and uses you as a mirror to see if the idea fits or looks ridiculous).  In both situations, the board assignment had lasted a number of years, so we were well past the initial burst of enthusiasm in which fundamental business principles and best practices are scrutinized every third day or so.  Instead, the bad company kept doing what it did poorly, and the great company kept doing what it did well.

What do we do in these situations?  One solution to consider is rotating board seats within your partnership.  This is rarely done.  We hate to give up our thoroughbreds, and we are loath to saddle our partners with a soon-to-be consignment to the glue factory.   It also takes a fair amount of time to build trust and chemistry among board members and management.  In the case of a company that is doing well, there are still critical trust issues that occasionally arise including, most importantly, when to consider selling the business.  Further, winners occasionally stumble, and the apparently low-value board might again be called on to be an active force.  Similarly, the underperforming management at an underperforming board is not likely to be amenable to my partner’s advice until my partner is ready to write a check, so the stalemate will continue (the exception is when personal relationships among the board members, and particularly among the investors, have deteriorated, in which case a change might be worthwhile).

I have found that the best approach is to meet, proactively and on an every other year basis or so, with management and sometimes with other board members for an honest assessment of how the board is functioning, including how I am functioning with management and the board.  In the high performers, the result has usually been a shift of focus onto areas where the company needs and wants help; management at these companies typically likes the board, appreciates an honest assessment and has a talent for extracting value from willing constituents.  In the companies in which performance is subpar and the relationship with management is strained, there is still a surprising amount of mutual agreement and often an opportunity to agree to disagree on certain key issues while still finding areas where important work needs to and can be done.  In the latter case, however, you have to be realistic.  After all, when you’ve told your wife you want a divorce, offering to do the dishes only goes so far. 


If Only Sales Growth Was Correlated With the Size of the Sales Team

We hear it from entrepreneurs so often.  “When Osage invests, the use of proceeds will be to ramp up the sales force immediately from one person (the CEO) to ten people.  With a conservative quota of $1.5 million per sales rep and a six month ramp, these nine new people should generate over $10 million in revenue in year one.   If we finish year one while continuing to ramp sales people, we should be on track for $30-40 million by year two.”

If only it was this easy.  If it was, this entrepreneurship thing would be a laid back effort and venture capital investing would be a sure winner.

But it is not so simple.   Let’s explore a couple reasons why.

  • It is hard to be a sales person for a small technology company selling to large entities.   This means that $1.5M quotas are hard to hit and the average sales productivity of a sales person at a tech start-up is far lower than quota.  The math looks very different if the average sales person is generating $750k per year versus $1.5M.
  • How do you know who to hire?  Sales people from big companies think success translates to small start-ups when often it doesn’t.  A person who delivered a $3.0 million quota at Oracle will most likely not deliver half that figure at a start-up.  Do you hire domain experience?  Technology experience?  Solution sales experience?  Do you hire people from successful start-ups?  Maybe you need to figure this out before you accelerate the hiring process. 
  • Innovative products need time for demand to build.   Corporations may not have budget.  Only thought leaders may be ready to implement the product.   Adding sales capacity does not ensure that demand will increase.   
  • Getting sales people to sell the product available today rather than the product of the future is hard.   When you say no to a sales person and tell them they cannot make promises, you are taking money out of their pocket.   If you say yes, you are slowing down the entire organization’s ability to maintain flexibility for the future.
  • When you hire 10 sales people, you need to hire additional sales engineers, you need more inside sales / lead generators, you need more marketing support, and the demo team gets overloaded.   More proposals and RFPs need to be reviewed.  Pricing structures need to be approved.   Product management and development get crushed with requests.  Activity goes up measurably, cost or stress goes up.  But do sales?  All this activity precedes sales by six months (or much more).
  • Turnover in sales inevitably occurs, causing distrust in the marketplace and confusion at home.   The fastest way to lose a good sales person is to give them an impossible task – on commission.   But don’t worry – the bad ones stay for the duration.

I had a VP of Sales once who was a truly pragmatic soul.   When he was asked if he needed more sales people to hit his number he would always look at his current team and ask if they were overburdened.  If not, he would say – “Let’s take the money and put it into lead generation – marketing, inside sales, etc.”  He would want his sales guys loaded up before I brought on more capacity.   He knew that increasing the supply of your sales people does not increase the demand for your product.  Smart guy – great sales leader.

Bottom line – more sales people lead to more activity and more activity leads to more cost.  More qualified opportunities and the right product targeted to the right buyer lead to more sales.  Figure this out before you put all your gas into expanding the sales team.  This entrepreneurship thing requires higher order math than simple arithmetic.