As I wrote here several weeks ago, I use a simple test to determine whether we're in a 'bubble'. That test says we definitely are. But, maybe there's room for one more nail in the coffin of the debate...with an oblique lesson for entrepreneurs and their startups.
When Groupon filed for its IPO, commentators (example) pointed out the unusual, informal accounting used by the Company. Yesterday, the SEC announced that it's reviewing that accounting (strictly speaking, Groupon does actually present its financial statements in accordance with GAAP (SEC requires it), but spends a lot of time pointing investors to a bunch of novel, more favorable, non-GAAP accounting measures that present a more attractive growth story than do the GAAP financials).
When companies start doing this, all I can think of is the last bubble, with bad accounting stuff happening all over the place: e.g., WorldCom recognizing hundreds of millions of dollars of revenue from bandwidth swaps, AOL recognizing tons of "revenue" on "round-tripped" revenue, etc. It's always been a harbinger of trouble, and, having been in the business for 30+ years, always forebodes bad news.
For early-stage entrepreneurs, there's an indirect lesson here: honestly and transparently report, analyze & deal with the core "financial" metrics of your business with your board and investors. When you are presenting, say to your board of directors, on the health of your startup, never lead with any statistic other than revenue and earnings (or losses -- as all startups have initially). As a board member, I can always tell how a company is doing, and how confident a CEO is in the business by how long it takes in the board presentation for the CEO to talk about (1) revenue and (2) earnings (however accurately defined for that business). When a CEO spends time talking about press mentions, conference awards, employee growth, buzz about the company -- but not about how the company is progressing towards the goal that all self-sustaining companies must reach -- receiving more from customers for what you're selling than it costs you to make and sell it -- you know your investment is in trouble.
My advice to startup CEO's: don't be afraid of this. Instead, embrace it. Stringently measuring yourselves against this standard shows your board and investors that you're serious and honest. Focusing on other "metrics" about how the business is doing to the exclusion (neglect) of financial accounting metrics is usually interpreted as a sign that your startup isn't doing well on what matters.
Postscript: this is not to say that other metrics aren't important. Particularly for startups building a "media" model, in which they need to generate large audiences for content (however defined), other metrics are also important: unique visitors, user engagement with the site, effectiveness of the site in getting users to help market the site to other users (virality, WOM, etc.). For businesses like this (more in a future post), it makes sense to pursue the GEM model: (1) Growth, (2) Engagement and (3) Monetization -- and, importantly, pursue them in that order.
To their confusion and exasperation, entrepreneurs often hear from VC's that the VC is passing on their deal because the VC doesn't see how it can be a "home run". Understanding how VC's think about "home runs" is important for entrepreneurs (and their advisors who help them with fundraising) in choosing which VC's to pitch.
Historically, the VC business has been a "hits" business. For most VC funds over a 10 - 15 year period, more than 90% of the returns come from fewer than 10% of the investments (this is, actually, probably conservative). Investments in the other 90% either go out of business or deliver meaningless-to-modest returns. This highlights the perils, quirkiness and luck-ridden nature of early-stage investing. It also, to some degree, explains why many VC firms that traditionally focused on early-stage deals are morphing into later-stage, growth equity funds (more on this in a future post).
So, what is a "home run"? Two factors determine the answer, one obvious, one more subtle.
First, the absolute size of the return is an obvious component: No matter what, the bigger the return, the more likely it will constitute a "home run".
The second attribute, however, is less well known: the ratio of the absolute dollar size of the return to the size of the fund.
Why is this? Shouldn't a $1 million investment that yields a $25 million return be good, bad or indifferent regardless of the size of the fund from which the investment was made? It's the same amount of money, and the return is a lot higher than the amount invested.
A major component of the answer is that VC's are principally graded by their LP's on what's called "times return", not so much on an IRR basis (though both matter). Briefly, "times return" means for every dollar invested by an LP, how many dollars does that LP get back from the VC -- over the life of the fund, not in any particular year. There are a number of reasons for this that I'll deal with in future posts, but the relevance here is that "times return" is very important for VC's and their LP's. More "times return" is better. One can also see that generating a good "times return" is easier on a smaller fund than a larger one.
Historically (lots of variation in this as you'd expect from a business as volatile as early-stage VC), VC firms that achieved 3X "times return" (on a "net" basis, which I'll explain in a future post) were in the top quartile of VC funds and had no trouble raising their next fund.
The "home run" nature of the early-stage VC business, combined with the importance of "times return" to the VC business model, means that entrepreneurs should focus their fundraising approaches on those VC's whose funds are appropriate to the amount of money needed and the possible size of outcome that an entrepreneur can reasonably (and credibly) portray to the VC. Approaching a $500 million fund (average for VC's in today's world) for a $1 million dollar investment is likely a waste of time. For a fund of that size, even if the $1 million investment returns 25X (a very good "times return" in VC-land), the resulting $25 million return (given the hits nature of the business) won't move the needle.
For a $25 million return in a $500 million fund (even on a $1 million investment), half of one's partners might remember to mention it to you on their way to the coffee machine (it not being worth a special trip down the hall to your office), the second half wouldn't think it noteworthy enough to mention at all, and the third half would say to themselves: "why did he spend so much time on such a crappy little deal?"). For a $25 million return on a $40 million fund, your partner(s) send you and your family to Hawaii on an all expenses paid week-long trip.
Size of fund is not, of course, the only attribute of a VC that an entrepreneur should consider in his fundraising approach (there are a number of others), but it is a very important one. More on others in subsequent posts.
In a deal recently, the term sheet offered by the prospective investor contained a reference to the term: "fully-diluted". The company accepted the term sheet and the lawyers drafted the documents. On review by the Company, however, it became clear that the parties had different interpretations of "fully-diluted". Due to some idiosyncracies of the company's capital structure, the disagreement had a significant impact on the deal structure.
While that deal recovered and closed, it highlights the need for entrepreneurs and investors to understand when so-called defined terms like "fully-diluted" actually need explicit definition in the term sheet.
The term "fully-diluted", unlike some legal terms, is not defined by any law or regulation. That is, there isn't any place to go "look up" what it means. This, plus the informal way the term is used in venture financings, puts a premium on the parties explicitly agreeing to a commonly-understood definition.
In general, the term "fully-diluted" attempts to capture the notion of how many shares of Common Stock would be outstanding if all securities of the company that either (1) are outstanding or (2) are available for the board to grant or issue actually become Common Stock in accordance to their terms. This "fully-diluted" number is sometimes called "common stock equivalents".
In essence, there are two kinds of securities that need to be considered in fixing the number of "fully-diluted" shares: (1) outstanding common stock and (2) so-called "deriviative securities". Many different securities can fall into this latter category, but usually in a startup company situation, there are the following 3 - 4 types:
Stock options (or "warrants", which are exactly the same thing, only called by a different name) that are actually granted;
Stock options that are reserved for future issuance by agreement among the company and the investors (various consequences occur if this number is exceeded, most commonly an antidilution adjustment to the effective "as-if-converted" price of the Preferred Stock);
Convertible promissory notes, which are frequently used in seed financings, and which convert into (usually) the series of Preferred Stock issued in the company's next financing;
Preferred Stock, which is usually the security issued in VC financings, and which converts in certain circumstances into Common Stock.
In this situation, the maximum, fully-diluted number of shares outstanding would be calculated by counting the number of outstanding shares of Common Stock, as well as assuming all the following had occurred and been added together :
The number of shares of Common Stock that would be outstanding if all stock options (and/or warrants) were fully exercised
The number of shares of Common Stock that would be outstanding if all stock options reserved for future grant were actually granted and fully exercised
The number of shares of Common Stock that would be outstanding if all outstanding convertible promissory notes were converted into (usually Preferred) stock and that Preferred Stock was then converted into Common Stock
The number of shares of Common Stock that would be outstanding if all outstanding shares of Preferred Stock were converted into Common Stock
There can be other, more complex securities (e.g. certain kinds of so-called "exchangeable securities) that also need to be considered in certain situations. The key to avoiding disagreements is to make sure that the parties have a common understanding of the types of "derivative securities" that are outstanding (or could be pursuant to current agreements), and that they agree on which of them gets counted as part of determining the "fully-diluted" number.
We have always liked public hangings in West, and we actually performed them until embarrassingly late in our history. Sometimes, we even held a trial before convicting and hanging the suspect. And, sometimes, the person hanged was even guilty. It's not much better today in the U.S. with elected prosecutors almost always using the office to which they were elected as a step along the way to a higher office. And, finally, the criminal justice system is deeply flawed when the alleged perpetrator is a predator and the alleged victim is a prevaricator. Although I rarely think highly of her columns, I do think Mauren Dowd captured this tension well on Sunday in the NYT.