Running the Funding Marathon

So what is the right value for raising institutional (venture) capital?

As with many things, beauty is in the eye of the beholder, or in our case, value is in the wallet of the investor. Whatever the market will bear is the real value of the company. This value may and will have nothing to do with the value your angel investors paid for their stock. It will have absolutely nothing to do with the amount of work you and your team put into making your product or putting together your offering. And it certainly bears no relationship to how much the company would have to be valued so that you retain control.

Rather than focusing on the paper value of their current ownership, founders should think ahead, through as many of the "gates" as they can forecast, that stand between them and commercial success (all the way to a liquidity event). It's like a marathon, as opposed to a sprint. The leader at the mid point is not necessarily indicative of the winner at the finish line. Not all money is created equal. It may be more important to get a good value, rather than the best value, from a partner who is in it for the long haul. This may mean taking a lower valuation today in return for accelerated market entry and mind share from a partner who brings much more than just capital to the equation.

Often we see founders falling prey to early angel investors "bidding up" the value of their companies during several cash calls in an effort to increase their short term valuations. While this may "feel good" at the moment, it could become a critical obstacle to their long term success. Founders should understand that it will be VERY DIFFICULT to later get an early investor to digest a crammed down valuation if these angel values were artificially inflated.

Here's an example: A plastics company in upstate NY purchases some very interesting patents from a large industrial conglomerate who doesn't view them as critical. They raise angel capital to begin to prototype this product. They run out of cash. Management either knew or should have known they would need more cash. They go back to their investors needing more capital. The investors agree, perhaps they bring in a few of their friends in this round, but only at a newly established higher value. This continues for several more years. By this time the company has yet to commercialize its product, yet the valuation is now in the double digit millions - based almost entirely upon the angel investors bidding against themselves to increase the value and to feel good that their investment is increasing in value. Has this higher valuation helped them?

Absolutely not!

They are now getting closer to being able to commercialize the product. They need sales and marketing funding, they need production facilities, they are ready for their launch. This requires capital in excess of anything they have raised in the past. So they seek out institutional investors. In fact as they become a bit more desperate, they also seek a strategic buyer. There are several interested acquirors - but they each in turn demur due to the demanded valuations. Ultimately there is interest from institutional investors (bigger fool theory in play here?), they can't justify the lofty valuations the angels' fictions have created! But the company needs the capital. And voila - cram down occurs. Founders get squeezed (out completely in this case). Early investors get burned. Later investors get fried! And company's prospects for success are still in doubt. But the founders felt great at these lofty values, that is at least until ... they got dumped!

What could have happened?

With some foresight, the founders might have begun to understand that the only real valuation that matters is the one just before they cash out. Restricting their fund raising rounds to smaller increases (or sideways) in value that were commensurate with their market progress, might have enabled them to keep the valuations in line and then be able to raise capital from institutions at an appropriate rate. Or, it might have enabled them to cash out in a sale to a competitor at a valuation they could stomach.

This vortex of capital raising can stymie the progress of even the most promising venture. So beware when you hear yourself remarking about how the world doesn't get your value proposition! The "best" valuation you can have for your company, may not be the one that momentarily makes you currently feel the richest.

Your Money or Your Life?

When is the right time and at what is the right valuation to seek outside funding? Founders and entrepreneurs constantly quip that the world (that is everyone outside of their four walls) does not understand their true valuation. Obviously, they know something that everyone else doesn't. (But do they?) And as such, entrepreneurs often wait, sometimes too late, to raise funds.

Sometimes waiting is exactly the right thing to do. If the product is not yet complete, the value proposition for the outside world has not yet been proven, or if the claims the company is making are just not yet credible to the financial community, this can be the appropriate move - assuming the company has the wherewithall to survive. But founders and entrepreneurs should be wary of continuing to push that rock by themselves for a bit too long and the implications that their "slow" pace of progress will have on their competitive strength.

Sometimes getting to market first is just not enough! The market is strewn with dead companies who introduced the next great thing to the market, only to bowled over by a better heeled competitor who follows in their path. Getting there first is part of the battle, having the resources to execute, to capture market and mind share, is a critical hurdle that must be overcome to be a commercial success.

The savvy entrepreneur should understand that having the appropriate resources at just the right time (no earlier - but certainly no later) is critical for maximizing the value of their opportunity. If your product or service is ready to be launched, but you delay due to perceived poor valuations, you may in fact be giving up much more value to the market than the lower-than-expected valuation costs you. If you miss a market opportunity, or enable a competitor to impinge upon your market space, or create noise or confusion in the market, you may just find that you have diminished the value of your creation beyond repair.

Founder Forecasts

Having recently spent a substantial amount of time reviewing new business opportunities, I'm beginning to realize just how hard it is to come to agreement on the value of an early stage company. I had thought that this would be challenging, and certainly it has been. However, I continue to be surprised by the metrics (or lack thereof) that are offered by founders and the shaky foundations for their logic. So below is my advice to founder-types on what they should avoid when trying to negotiate the worth of their progeny with any outside investor.

First Lesson - You can't use discounted cash flow analysis as a method to measure value when there are no cash flows. Almost every time a valuation discussion with a founder begins, someone whips out a discounted cash flow analysis. I guess business schools all teach some version of DCF. and perhaps business incubators perpetuate this teaching by suggesting it to budding companies. But the DCF method for valuing a business was based upon "predictable" cash flows. Without predictable cash flows, applying mathematics to speculation does not make the result any more real. And, increasing the discount rate to account for the "risk" that these cash flows may not occur, while better, still results in factoring a mathematical formula against a speculative occurrence - still not helping the result to become any more real.

Lesson Two - One or Two Customers does not a trend make. As Abraham Lincoln once said: "you can fool some of the people all of the time." And this is often just the case. Or at least you haven't yet proven that your idea has widespread appeal. Extrapolating value from the first few customers to anticipate broad market acceptance is at best optimistic or at least premature. In mathematical terms, you need a set of points, not just the first few, to spot a trend. Early adopters are just that. Market acceptance occurs as Geoff Moore would describe, when you cross the chasm, when real customers purchase products as a matter of course, not as a pioneer. Anything less may be an indication of future opportunity, but certainly not proof.

Lesson Three - You can't pay your bills by trying to cash in on someones interest in your solution. I can't tell you how many times a founder has told me that things are going great because several potential customers, partners, venture capitalists, angel investors, (you can fill in the noun here) has told them how "interested" they are in taking the next step. I can't speak for everyone here, but it seems like a very American personality trait to use the word "interest" to mean "please leave now since I have a lot of other things to do and I would rather not tell you how I really feel about what you are trying to convince me of." If you don't believe me, try being a bit cynical next time someone tells you how interested they are in what you are pitching. But even more important, interest (even if real) is a long way from cash in the bank. Founders by nature are optimistic. But they need to gain a healthy does of cynicism and perhaps an objective sales process, before they can begin to value the "interest" they are receiving.

Lesson Four - While selling the first few of anything may be difficult, it doesn't mean your organization will be capable of selling a sufficient quantity to become profitable. I recently became enamoured with an early stage company and its solution. I spent a good amount of time investigating how the company was selling its solution. What I found was that the direct cost of sales and implementation was something in the range of 10X or more the gross revenue the company would receive from this customer (who had shown interest - see lesson Three). But just like the businessman in the well told joke, I was told, don't worry about the cost, we will make it up in volume. Well, really what I was told was that these were just early sales and in the future this would be much easier and cheaper. While I agreed that there were some very clear ways to reduce the cost of sale, there was no real plan for doing so. No one had thought through how they were ultimately going to deliver this solution at a profit. And while early cash flows and even beginning profits are interesting and necessary, unless the company is capable of generating some kind of real gross margin on its solutions, this is no place for an outside investor.

Lesson Five - Sometimes you have to give up more than you would like to get your idea to market quickly enough. I've run into several situations with founders who need to raise capital, but they only want to raise a small amount because too much will be too dilutive to their early investors and themselves. I always approach these situations with admiration. I too would want to not give up any more equity than necessary if I had a early stage company that I believed was quite promising. However, don't let dilution blind you to market reality. If your idea is good, then get it to market. If your idea is completely protectable - i.e., you got an encompassing and defensible patent that will be difficult to work around - you might be able to ignore this lesson. For everyone else, if you slowly inch your way into the market, and it is in fact a good idea that you have, as soon as you have proven sufficient viability, you have opened the door for someone with more capitalization and more resources to steal this market from you. Taking market share early is often the best tactic. To borrow and idea from a seminal marketing book Positioning authored by Ries and Trout: getting to market first is important, but getting there firstest with the mostest (big presence and share) is critical. In today's global market, you can be sure there is someone somewhere who is waiting to pounce. If your slow path to market risks someone taking over leadership ahead of you, it would likely behoove you to take the larger-than-you-would-prefer dilution, and ramp up your plans early.

So how does this help you come up with a mutually acceptable valuation? My advice is be honest. Most investors (with some notable exceptions) do not want to steal your business from you. Usually, it is more important to have you completely engaged in the business, than it is for the investor to get your equity at a bargain price. Investors like to have rational conversations with factual underpinnings. They often are enthused when they hear some healthy skepticism in their conversations with founders. If you can run the business and grow it fast enough without asking for any outside funding then do it! But if your business model requires that you capture market share and ramp up sales more quickly than your personal capital requires, then understand that being realistic may be just the ticket you need to capturing a share of the investors wallet.

Sticking around too long?

I recently was referred to a blog post on Fred Wilson's Musings of a VC in NYC. Fred suggests that keeping a founder around post his replacement - moving "up" as he calls it - is an important positive development. I think Fred may not realize that while it may have positive implications for the right personality founder, it may pose some significant issues for the hired gun CEO who steps into a position which perhaps may have been previously filled by a "legend." Forcing a newly hired gun CEO to operate in the shadow of a large personality who has accomplished the impossible of starting and building a substantial company from scratch, while someone remains to look over his shoulder, can be an undue burden that hinders rather than helps the company. The fact that many founders return to their old jobs years later may not be as good a prescription as Fred leaves us to believe.

Good CEO's are not puppets. Moving the founder "up" to become the puppeteer to manipulate his strings (unfortunately what it appears happens with some founders who stick around), is likely not what you hired his successor for. When change is required (which often is the reason for replacing the founder to begin with) keeping the old guard around and still "in charge" as Chairman, can be a sea anchor on the successor's ability to implement change. It is a unique founder for sure who does not try to perpetuate their own ideas even when moved out of the CEO role.

Witness what may go down in history as one of the best performed transitions (albeit not of a founder, but the analogy certainly still holds) with Jack Welch giving way to Jeff Immelt. Jack carefully picked his successor after years of scrutiny (may be a big lesson there too on the care taken to select the successor - See my posting on Try Before you Buy) and then left the company entirely, in order to enable Immelt to do the right thing and not be encumbered by Jack's legacy. Jack clearly was quite a successful CEO. By all rights he could have stuck around and "helped" Jeff transition the company into its next stage. Instead, Jack felt it necessary to get out of the way. In fact, Immelt undid many of the well worn strategies that made GE successful during the Jack Welch era. But Jack was smart enough to realize that change was necessary and chose a capable successor, gave him the keys and waved him goodbye.

Is Jack available if Jeff needs him? Sure! But he is careful not to have his shadow restrict the vision that Immelt requires to take the company to the next level.

Slicing up the Pie

One of the toughest moments for a new founder/CEO is when she realizes that success requires she begin to slice up the pie. Sometimes this happens first when its time to attract or compensate early employees - not all of whom are willing to take severe pay cuts without something in return. Or sometimes her first encounter is when it's time to raise some outside capital. But how big should the slices be? And how many of them should be cut? And what does this term dilution that people keep throwing around really mean?

The "pie" analogy is often used to describe the cutting and serving of slices of the business often in return for something of value. Whether this is a pizza, lemon meringue, or other category is not necessarily the relevant question. Venture capitalists will talk about "increasing the size of the pie" - usually about the time they are angling to cut themselves an oversize slice. And founders are often times seen giving out big servings to their original founding team without thinking through how many her pie will feed.

So there are several important considerations for how, when, why and how much, and to whom to serve from this founder's pie. Below are three common mistakes that the unwary founder may be (mis)guided to endure.

Common Slicing Mistakes

• Excessive Portion Sizes for Early Employees - Early stage companies are often run like families. Sometimes they in fact are families (see Why CEO's Fail). Close knit groups of employees come together to do the impossible. To create something extraordinary from nothing but a vision. They dream dreams of (market) power and riches beyond most of the founding team's conceptions. They work hard, often in close quarters, and form strong interpersonal bonds. Many times these bonds cause founders to mistake relationships for value. At what Venture Capitalists might consider a "weak moment" for the founder, large slices of the pie are doled out early to the founder's team.
  
  
• Using equity instead of cash to pay operational costs - in the earliest stages of a new venture, it is common for cash to be dear. There is much to get accomplished and too little cash to "pay someone" to do it. So often founders are induced to use equity (another slice of the pie) to substitute for cash. Whether this be for a bargain property lease, purchasing of equipment, or hiring a consultant, equity may be all the founder has as a currency to purchase these resources. So necessity itself is the mother of this mistake. And, although there may be little alternative than to use equity, the cautious founder should realize that while these expenses may be real, the use of equity is akin to mortgaging the future of your venture "just" to get this resource today.
  
  
• Unwilling to create slices that increase the size of the pie - the flip side of the prior error is the contrary position. There are times in the life of a new venture when resources present themselves, in the form of unique talent, critical opportunities, and cash funding. Founders sometimes find themselves unwilling to part with even a relatively small slice of the pie, even though these resources may only be fleetingly available and could materially grow the size of the pie.
  
  

So how does a founder avoid these mistakes? Some forethought about the end result and understanding a bit about dilution will certainly be helpful.

There only is One Pie to Slice

The first thing to understand when slicing up your pie is that there is only one pie to slice. Better put and despite some notable con-men to the contrary, you can only give or sell 100% of your company. That means there are a limited number of slices. Once you cut a slice out of the pie, that slice is gone. Even if the pie gets bigger (the venture gains value) that slice will grow proportionally as well.

Early stage employees may be very important to the early stages of a venture. It is common for these early stage employees to be just that: good early stage employees. They may not be capable to take the company to the next stage. They may have to be replaced by new talent at a later stage. Realizing that giving up an extraordinarily large slice of the pie early, may leave you "slice-less" later when your venture needs to attract talent that may not be willing to work for just a salary. Employees may come and go, but there only is one pie.

When you pay for current expenses using slices of equity, you also should be thoughtful about what that means at a later stage. Remembering you only have one pie, while realizing your expenses will continue forever (they are recurring), will help you to understand that you won't be able to use slices of your pie for ongoing expenses forever. Therefore if you have to use slices to pay for ongoing expenses, be sure you know when you can reverse this trend. And, while the size (value) of your pie (entity) may be small today, most people value equity based upon future value. [Our own public stock markets are really valued based upon the potential value the ownership right (shares) that you purchase. Financial types often speak about discounted cash flows - or the value of this share of the company based upon expected future results.] So if you use stock to pay for current expenses, be sensitive to this valuation process and don't sell yourself short.

Increasing the Size of the Pie

Being realistic when opportunities arise that will grow the size of your pie is equally as important as careful scrutiny of giving out early slices for employees or expenses. Your value (the size of your slice) is truly dependent upon BOTH the proportion of the piece you have for yourself AND the size of the pie. A 1/4 slice of an extra large pizza is bigger than a 1/4 slice of a personal-size pizza. Understanding what will grow your pie is critical. When angels or venture capitalists offer you cash in return for a slice of your pie, you must look at the impact that financing has on the size of your pie.

Here's a quick lesson in pre and post money valuation.

Venture capitalists speak to you about the value of your venture. They may offer you $1 million for a 33 1/3% share in your venture. To you that means your venture is worth $3 million. Once you get their money your whole pie will be $3 million sized - that's the size after they added their $1 million. By simple math - the "pre-money" size of your pie was $3 million less the $1 million they added - or $2 million.

So based upon this financing offer - you used to have a $2 million pie that you had unsliced - all was yours. The VC is offering to increase the size of the pie another million larger - now $3 million. In return, they are going to take a slice that is 1/3 of the pie (1/3 of $3 million). You get to keep 2/3 of the pie or $2 million of the size.

So in this case the pre-money valuation was $2 million. The post-money valuation was $3 million. Assuming you both agreed on the $2 million pre-money valuation of your entity, the new financing was not dilutive - did not reduce the actual size of your slice. While you now only have 2/3 of the pie left, that slice increased in size sufficiently to leave you with the same amount (to eat?). While the amount of (surface area) of the slice of the pie that you still hold has neither increased nor decreased, the financing has put you in a position to continue to grow the value (size, surface area, value) of your pie into the future. You now may be in a position to stop using pie slices to pay for current expenses. You now may be in a position to attract the kind of talent you require for this stage in your venture without giving up too many large slices of what you have remaining. Overall, taking on the cash should help you continue to grow your pie beyond where you could take it yourself.

Of course you always could be happy with the size of your current pie. You always could decide that there is no need to grow the pie. Those are your decisions. But understanding and accepting that outside resources may be required to ultimately grow your pie to the size you desire, and that to do so may require you reduce the percentage of the pie that you own, will be critical to how you deal with the distribution of slices and the raising of outside capital.

A very bad Transition

A good friend of mine in Austin, TX, Hank Jones (Henry W. Jones, III Esq.) who is an industry pundit and expert on Open Source issues, sent me information on a founder transition that really went awry. According to allegations filed by the company in the Superior Court in Orange County, California, Medsphere apparently twice tried to find a CEO to take over from two founder brothers ( Why CEOs Fail?). The first ended abruptly less than a year into the new CEO's tenure when the brothers forced the Board's hand. A second CEO was recruited with even more egregious consequences. According to the company's amended complaint, the two founder brothers got so angry at the direction the new second CEO put in place (only three short months after he took over), they clandestinely published the source code for the company's proprietary software as open source. That certainly put a crimp in the new CEO's plans (see his letter regarding the company's open source stance). Wow! Talk about a bad transition! Boards everywhere should be paying close attention to how dire the consequences of a bad transition can be and what an awkward position they can be put in when founders join together to counter a new CEO.

2-Feb-07 --> The story continues to develop.

Try before you Buy?

Most of us who have been through or witnessed a founder transition would agree that this is no doubt a tricky process fraught with potential disaster at nearly every turn. Yet the process most companies and boards engage in with the potential CEO replacement is one that is set up for failure. And failure is what too often results.

Several interviews with various members of the management team and board, some surface level background and reference checks, discussions with some "insiders" who know what this candidate has done in the past, can never be sufficient to really know whether the most important criterion for successful founder transition will be met. That criterion is the chemistry and relationship that is required between the founder and the newly hired CEO.

While most of the "hard" criteria for founder/CEO transition can be learned using a time tested recruiting and interview process, the "soft" skill compatibility can probably never be really understood without trying it out. In-the-trenches interaction between the potential candidate and the founder and team might actually be the only way to really know if this transition will work.

Any organization that can avail itself of the opportunity to try-before-they-buy should take full advantage of that by engaging the CEO candidate as a consultant in advance of a final hiring decision. While this can be awkward for the candidate (confident and experienced candidates will relish this opportunity) and potentially a delay in the final decision for the recruiter, board and the team, finding out early that this relationship is not going to work is a small price to pay to avoid making a bad decision.

Why CEOs Fail?

One of the most compelling articles ever written about CEO failures has many lessons for Founder/CEO's as well. In June 1999 Fortune Magazine published the article: Why CEOs Fail? The lesson was that CEO failure was generally not caused by a disagreement between the CEO and his/her board, or even a failure of strategy. More often, failure was a product of relying too long on key employees who just weren't cutting it. The CEO's failure was the refusal or unwillingness to get the right people into (or probably more important - out of) the right positions due to personal relationships that had grown between the CEO and his/her team.

Attributing the same characteristics to the founder/CEO seems to be all too appropriate. Often the Founder brings family (husbands, wives, brothers, parents), close childhood or school friends, or others with whom the founder has had an other than pure business relationship, in as early trusted employees. No one would argue that it is hard to sever those relationships; doing so might have severe implications for their outside-of-the office life. However, the implications of maintaining these relationships beyond what is good for the company can be critical to an early stage venture's prospects.

We've seen dozens of ventures that have either failed or been critically wounded by the presence of fairly nice but incompetent friends and family holding positions of authority. Not only does the lack of competence in their particular field hinder the company's success, but it also has a detrimental impact on other employees who have only their objective performance on which to rely.

Certainly the writers of this article (now gone on to fame as pop business book writers) were not focusing on founders when they wrote this piece. However, founders should pay close attention to the issues identified and realize the implications of a more-than-business relationship in the workplace.

Founder adoption

There is no closer analogy for the hired gun CEO taking over a founder run business than adoption. Founders "baby" their startups, spending inordinate time and attention nourishing them during their early years. Mistaking taking over for the founder (especially one that remains involved in the business) for anything less than this level of emotional attachment is a fatal mistake.

So when I made the decision that we needed to change the name of our company as we positioned ourselves for market expansion, I knew I was in for a difficult process. The founder of my company had been its leader for almost 18 years by the time I took over. He had painstakingly bootstrapped the company and had done so quite successfully. Deciding only after this time that he was finally ready to take on some institutional capital in return for a partial cash out, he agreed to replace himself as the CEO.

The transition from founder to hired gun CEO actually went pretty well. We worked closely together, he as a mentor and me as a change agent. I made no material changes without a detailed discussion and rationale with him and ultimately, if I was passionate about a change, my direction was adopted. If not, and we disagreed, he often was able to talk me out of it.

This arrangement worked quite well. The company grew quickly during the first few years of the transition, culminating during the heat of the market runup in 2000 with us taking on some strategic investors (two of our clients) and our founder being able to cash out even more of his holdings at a very nice multiple. It was at this time, that we decided to expand our business. As our team reviewed the alternatives, one of the ideas that became clear is that we needed a bit more expansive name than the TLA (three letter acronym) that we had adopted as our call letters. So after much painstaking process, and many rejected attempts at renaming the baby, we all agreed (founder included) that the change would go into effect.

We positioned the name change to be announced at a gala affair we had arranged in conjunction with the San Francisco Giants baseball team. We had rented out (then called) PacBell field to invite some of our largest customers, partners, and investors to play ball with Vida Blue and Mike McCormick - two former Cy Young award winners, in a charity event. The idea was to make a big splash with our marketing repositioning.

The founder and I dressed in our best baseball garb in the visitors' club house and began the long walk out from the clubhouse through the dugout onto one of the finest baseball stages in the world. As we were coming up the steps of the dugout onto the field, the founder turned to me and matter-of-factly told me that he had changed his mind and that he was withdrawing his support for the change of name.

Fortunate for me it was too late. I pointed to the scoreboard out in center field that glowed with a welcome message with our new name and logo. The deal was sealed. The baby was renamed, and we all lived happily ever after. (By the way, four years later we sold the company for a slightly lower multiple than the heady valuations of 2000.)

The moral of this story? Don't take lightly the responsibility and emotion that is involved with adopting a founder-based early stage company. There is much more involved than meets the eye.

Rich or King? A founder anomaly.

A phrase often used by venture capital investors when investigating the motives of a founder entrepreneur is: "would you rather be rich or king?" This arguably gets at the crux of whether or not the founder would give way to the greater good and relinquish his CEO role in return for the riches of success without him leading the way. Savvy founders looking for capital from these deep pocketed venture investors have learned the right answer from the VC's perspective is Rich!

It's not clear whether the Venture Investors are really seeking the truth or just want to see if the founder is savvy enough to answer this inquiry "correctly." But virtually every founder that I've interviewed has a good deal of king (or queen) in his (her) plans. Sure, founders may be seeking riches and financial rewards for their sacrifices and hard work. But ultimately, most founders found companies in order to run their own show (translate into rule their own kingdom).

And doesn't that make sense? Many of these founders were very successful corporate executives, earning good salaries, receiving nice perks, and enjoying the supporting casts of their established employ. Founding a startup involves leaving most of that behind, starting over from little, doing it mostly on your own, and usually getting paid very little for the effort. While founders may dream of some day hitting it rich, that may be a long way off. But the very day they start - they start as duke, albeit over what may be a very small duchy.

The transition to professional CEO usually occurs (is forced upon them) well before they begin to enjoy the promised riches. So the choice for the founder is more appropriately: "would you rather be king or would you rather bank on someone else to lead you to what might someday be the riches you originally envisioned." Not quite the same choice originally posed by the VC during the courting ritual.

So VC's will most often hear the answer that they desire. And founders who need the capital, will continue to answer expeditiously, no matter what their actual motivation.