The evolving venture capital business
Before I got into the venture business, it seemed like there were a number of rules that many VCs held as sacred.
I won’t go into all of the “rules” on this post, but the most typical one was the “20% rule.”
The idea was that VCs would tell founders (and their limited partners) that they always own 20% of the startup at the time of their initial investment.
The reality is that since we started Spark in 2005, we haven’t embraced that rule. (We try not to have too many rules actually). Sometimes we own 20%, sometimes we own more and sometimes we own less. It depends on lots of things.
And this approach has served us well. Many of our best investments have come from startups where we ended up owning less that 20% initially but either a) the startup radically increased it’s value over time and our position became worth tens or hundreds of millions or b) we were able to respectfully increase our ownership over time thru one or more inside rounds that were good for the company and good for us.
These days I see a lot of VCs also ignoring the 20% rule and it seems to come in four flavors. Some are more challenging than others - because of their nature and because of other things like fund size and team. It’s a complicated subject but I’ll try to be direct and hit the high notes.
Scenario 1: VCs are leading Series A investments and because valuations are going up these days, VCs are owning less than 20% on a pre-revenue and/or early stage product. That’s just the reality today. Or the valuation isn’t that high but the founder is very dilution sensitive so the company raises less money. In any event the VC doesn’t own 20% and that can work as I mentioned earlier. We’ve done this and will continue to do this.
Scenario 2: Later stage deal where a VC invests tens of millions of dollars and buys less than 10% of the company. For a given a certain fund size, this can be a great investment from a cash on cash basis. I like and respect this more when it’s done in coordination and support of the company (thru primary or primary and secondary) vs a VC just buying shares on a secondary market where the company is blind to the transaction. It still may end up being a stellar investment but that’s my bias on this one.
Scenario 3: Early stage deal where a company raises lets say $2M and there are 3-4 VCs in the syndicate. Sometimes all the VCs will split the deal evenly or there will be one lead VC and the others split up a minority interest. In the case of the latter, where a VC invests in a tiny fraction of the deal, it can be mathematically justified since they will most likely be passive and let the main VC do most of the work. I’ve heard some VCs call this an option on the company, or spray and pray or other things. I’m not super comfortable with the passive model for VCs and will come back to this point.
Scenario 4: A new round comes together and there is a new lead VC which gets to buy the bigger piece of the round. And then another VC comes into the round and suggests to the company and the new VC to let them invest a small/tiny piece and in exchange for being active and providing value. The VC getting the smaller piece in this case convinces themselves that they want to be close & active to the company because they love the product/team and hopefully can increase their ownership in follow on rounds. The founders agree because they want the small VC to be involved. Sounds like it works for everyone, right?
Well the answer is messy at best. The reality is that the small VC may only own 1-2% of the company after such a round. And if they do that type of deal a few times and become involved, then you have a scaling problem (which is problematic because it’s hard to scale venture capital to begin with).
The mathematical formula says that a VC should stay away from these types of deals or you should be passive.
We have invested and will continue to lead investments in Scenario #1 and #2 (in addition to leading more traditional seed investments, etc). I don’t see us doing Scenario 3 as a small passive VC. I’ll never say never but I just don’t see it at the moment.
So that brings us to Scenario 4. The math says we should only do it if we can be passive. But I don’t know how to be passive. And when I look around the table at our firm, I don’t see any of my partners being passive either. So that suggests we should just skip these rounds altogether.
But I don’t think I can. If I love the product and company then I love the product & company. And I’m not gonna let the near term math tell me what to do.
Interesting times for sure. It’s clear that this venture capital business is evolving.
Stock options: vesting & change of control
Fred has a post about option pools and their impact on valuation this morning. It’s a great post and will be very helpful to many folks without a doubt. I share the same point of view and it’s one of many reasons I like co-investing with USV.
Once you set up a pool there are some typical and different ways to structure the terms and rights associated with them. There are number of issues but for this post I want to talk about vesting & change of control.
Vesting
Vesting is important for retention but more importantly it allows the company to put the equity in the hands of the folks that have put in significant time & value into the company.
We have a vesting schedule with our team at Spark Capital and I’ve had a vesting schedule everywhere I’ve worked previously.
Since startups require a fairly long time to create & build the company most options have a 4 yr vesting schedule (or less especially if the team has been working for some time) with some sort of initial hurdle period - also known as a cliff.
The structure I’ve seen the most is one that requires the employee to work at the company for a year before vesting any options. At the one year anniversary they vest 1/4 of their option grant on the spot. After that they vest the balance of their options on a monthly basis.
I’ve seen cliffs as low as 6months and in some cases I’ve seen zero cliff. But the latter is extremely rare and I don’t like it much.
Change of Control
This is a term that describes what happens to the employee vesting schedule if the company is acquired by another company.
Let’s say you work at a company for 2 years, vested half of your options, and the company is acquired.
If the company option plan doesn’t have a change of control provision then either:
a) everyone lives with their original deal. You own what you vested. If you remain with the new company you vest the balance as you continue to work
b) a new deal is cut between the company/employees and the acquirer. The terms become jump ball at that point. New compensation, new vesting, retention bonus’, etc.
Founders like to have some sort of change of control acceleration. I’ve seem partial or full acceleration upon a change of control. That means at the time of the company sale some/all the invested options vest.
The challlenge with the change of control acceleration clause is that the buyer (acquirer) most of the time is buying the company because of the people that created the value. So if the employees are fully vested at the time of sale it will impact the purchase pice of the company.
One compromise I’ve seen is a “double trigger change of control” clause. That means the acceleration only happens if the company is acquired and the employee is fired without cause.
It’s a reasonale compromise. Although the double trigger will impact price and will make the acquistopm a bit more complex. The other issue is that it sets precedent. If you give it to yourself as founders and your senior team this right, than most likely you will have to give it to everyone in the company. You don’t have to of course but it can become complicated when everyone has a different set of terms.
Keep it clean & simple
I believe startups should adopt a clean and simple stock option plan. The cleanest way to do this is to make sure everyone has the same terms and rights (not everyone will have the same strike price which is expected and fair). And its a plan that you can live with as the company grows and won’t cause complexities in the future.
Exit Strategy
When I meet an entrepreneur for the first time I like having a conversation about the idea or see the product (or prototype) in action or even a “chalk talk” for those of us that are more visually inclined.
I’m generally not a fan of slides, especially if it’s an early stage company.
But if the founder wants to use slides then I usually go along. Founders should use whatever tools they feel most comfortable.
The one thing I am allergic to is when a founder includes a slide that says “Exit Strategy” and then has a few bullets that says “IPO or sell company to company a, b or c.”
Oy.
An early stage company should be thinking about how to create something great and how they want to get there. How to build value. Not think about exits.
Now most VCs that I know feel the same way about that dreaded slide. But there is a topic where I’ve seen disagreement amongst successful VCs related to the concept of exits when considering an early stage investment. Some VCs will think about who might be the potential buyers of the company.
They do this analysis upfront because most companies never go public. So they want to know if there could be multiple buyers of a company someday. If there aren’t any potential buyers then they it might impact the VCs decision.
I don’t see the world that way.
If you build a great company then you don’t have to worry about exits because you will have many options (e.g. public, get profitable & stay private, secondary offering, sell the company).
I believe there have been many exits where the actual buyer wouldn’t have been on any list at the time the initial venture investment.
This is just speculation on my part but at the time of the initial investment in the following companies who would have guessed the ultimate buyer:
-Flip Video (Cisco)
-Danger Research (Microsoft)
-Daily Candy (Comcast)
-Sling (Echostar)
-StumbleUpon (eBay)
The list goes on.
Yes, you can imagine the strategic rationale for those deals. But not on day 1 of the venture investment. The world just moves too fast to try and predict this stuff. And it’s not the most important question anyway.
We would all agree, the real question is whether a particular team & product can make something special.
Update: A few folks have reblogged this post and disagreed with me. To be clear, I never said exits aren’t important. I just don’t believe it should be something founders or VCs should think about at the start.
Paying attention to anti-VC opinions, part II
Last week I wrote a post suggesting that all of us venture capitalists should pay attention to the anti-VC opinions out there.
While I am proud of my work, our firm and many of the outstanding VCs we co-invest with, I realize there is plenty of anti-VC opinions out there. We owe it to ourselves, our customers (entrepreneurs) and shareholders (LPs) to pay attention to the discussion.
And there is always room for improvement. Nobody is perfect :)
I thought I would expand on this topic with a few examples & suggestions:
Employee Non-Competes
I think we VCs need to stop the double standard when it comes to non-competes. We can’t insist on locking up employees under a non-compete agreement in states that enforce them (ie MA) and then somehow fund entrepreneurs without any reservation in other states that don’t enforce them (CA). Let’s get rid of employee non-competes everywhere.
Pay to Pitch
In recent months I learned something that I didn’t know was going on. Some angel groups are charging entrepreneurs to pitch. Brad Feld said it best in his post, An Angel Group Move That Makes Me Vomit. Since then Charlie O’Donnell, Jason Calacanis and Fred Wilson have all weighed in against this practice. I completely agree. That isn’t cool and I won’t participate in any events that charge entrepreneurs to pitch investors.
VC Speak
Fred wrote a post yesterday about the VC speak - “we need to own”. It’s an excellent write up and it’s another area where VCs can do better. Instead of a “we need” it argument, it should be more about “we want” to see in this investment or not. This is what I wrote in the comments.
The other thing that came up in the comments on that same post was the expression “our companies” by venture capitalists. It drives entrepreneurs crazy and I can see why. It’s much more accurate and respectful to say “our portfolio companies”. Credit where credit is due.
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Clarification: I can already see the faces of some of my VC colleagues that read this post. It may sound like I’m coming off as holier than thou which is clearly not the intention. Like I said before, we all can improve and I realize I’ve still got plenty to learn. Fortunately I’m surrounding myself with people that I like, admire, respect and teach me along the way!
