VCs vs. Angel

Recently, there have been two interesting blog posts that once again highlight the ambivalence between choosing either a VC or private/business angel investor. One very entertaining rant(!) from Paul Jozefak (Liquid Labs) that focuses on the “more than money” promise each VC makes. He has a very clear opinion what VCs really provide and how their “advertising talk” should be evaluated by future entrepreneurs. (LINK) “Enough with the Kool-Aid though….without your money most entrepreneurs wouldn’t really care much about you. It’s OK, you still have your triathlon, cycling or foodie friends.”!

Protonet on the other hand has chosen to ignore higher valuations and instead go with angel investors. More about their rational here: (LINK). Interestingly enough they left money on the table in order to go with business angels among other reasons due to the easier negotiations and less tight up management time. This is often an overlooked point – VCs are experts when it comes to negotiating deals (given that aside from trying to get a proprietary deal flow that is their only other expertise ;)). If you negotiate with experts you have to take into account that these negotiations will be very drawn out. Your starting point will most likely be documents drafted by a VC who has written many, many preferable treatment clauses in the documents before negotiations have even started. So time and complexity of negotiations is an important consideration beside the price tag.

Does that mean you should leave VC cash on the table and always go with angels? Probably not … this approach will only work for smaller financing rounds – angels will bottom out if you are looking for 1m+ x – or you have to take so many angels on board that it becomes annoying to keep all of them in the loop. They will also have a very limited ability to go for another round or to provide additional capital on short notice.

So chose carefully when you are planning to raise additional funds. Make sure you understand the major pros and cons between investors and try to determine what your long-term strategy looks like. Are you going to raise more funds down the road? Do you need certain individuals in order to grow your business? Will VC connections support your business right now? … … lots of thinks to ask yourself and unfortunately this is highly subjective and there is no clear right or wrong here.

What are the implications for start-ups?

cont’d from last post VC funding…

Does it matter whether venture capital is a failed asset class or not? Yes, some capital restrictions will apply but I would argue that there are sufficient alternative sources of capital to not significantly restrict new venture creation. Smart entrepreneurs can bootstrap, rely on angle networks or newly emerging crowd funding platforms in order to bring a venture through the proof of concept phase.

Additional follow-up capital rounds can then be financed through trade investors who are currently committing significant amounts of capital. There is a significant interest from trade, publishing and pharma companies to invest in digital start-ups. These companies have hundredth of millions available for new venture creation or “corporate innovation” outsourcing. Almost daily new funds, initiatives or deals are announced by corporates who are looking to mitigate the impact of digitalization on their core investment business. These sources of funds should be able to replace venture funding (at least in Europe). In addition, German/European entrepreneurs are also cashing out and are ready to invest in new ventures. In Hamburg there is a wide range of angle / VC money available from successful industries partners e.g. HackFwd – Lars Hinrichs. 

Therefore, I would argue that especially in Europe the decline of the venture capital industry does not create significant problems and is compensated through alternative sources of capital.

What consequences does this bring for VC funds, which have fully invested their current capital?

As discussed in the previous post – times are tough for VC funds – but what implications does that bring? Funds need to start lasting value creation to attract new capital! As a first step I think that VCs need to reevaluate how they select investments. So far the industry has a way too high failure quote – I even think that VCs with their general herd behavior often miss interesting opportunities. Secondly, they need to increase their target range. There are lots of successful start-ups outside of the Silicon Valley and SV like hubs that would present interesting funding targets. Thirdly, they really need to develop beyond pure capital providers. Almost all of them will tell you that they are really value add above and beyond capital – that is generally just a statement but far from reality. Increasing number of start-up accelerator programs indicates that pure venture capital financing is not successful. More skills, support and knowledge are necessary. Investing in a VC environment is incredibly hard and finding the right investment criteria and sticking with them is quite a challenge. This is nicely described in Paul Graham’s “Black Swan Farming” article. Source: http://paulgraham.com/swan.html

Small is beautiful

VC firms should also stop raising larger and larger funds. Even if they successfully invested their smaller funds it does not meet that they should now double or triple their fund size. In several articles and also in the conclusion of the Kauffman Foundation report the authors argue that only smaller VC funds are able to provide decent returns. In addition, they focus a lot on the compensation structure and clearly show that having a significant amount of “skin in the game” is necessary to get solid returns from a VC management team.

„The incentive for small funds is aligned with investors and more achievable. A $100 million fund could buy 20% of 25 startups and handily outperform the public markets by building four to five companies into $400 million exit values, or a broader set of successes across the most typical venture exit values of $50 million – $500 million. Annual fees keep the lights on in the meantime, while the potential profit share from generating 300­400% gains provides the prime incentive.“

Source: http://venturebeat.com/2012/08/18/lean-vc-why-small-is-beautiful-in-venture-capital/

Compensation for the industry should also be changed. Funds will have to proof that their management team is not only investment savvy but also resourceful and has significant skin in the game.

While we agree on Kauffman’s recommendation on looking beyond large funds, a deeper analysis suggests the need to look at the risks and returns in the fund structure — the profit share of each partner, the spread of capital committed per partner, and so on — and remove the reliance on a heroic grand slam as the only, yet unlikely, path to outsized results. Other qualitative factors include structurally leveraging all partners’ expertise across the portfolio, and garnering meaningful returns from more than just a few deals. These are among the many critical and structural advantages of the smaller venture fund.

Source: http://venturebeat.com/2012/08/18/lean-vc-why-small-is-beautiful-in-venture-capital/

If these challenges are met successfully VCs will continue to play a significant role for start-ups – if not it looks like the industry’s funding sources will dry up and soon start-ups will have to look for funding elsewhere.

(b) Bankers, accountants, lawyers, consultants, fund raisers – how to deal with eCFO service providers

Lawyers

Depending on your business you should consider building a junior legal presence in your business to avoid having to pay high hourly rates for all legal related questions. This is especially important if you deal with legal questions, contracts etc. on a regular basis.

If you do have to hire a lawyer always go for the best and somebody with specialized knowledge. If your counter party has to negotiate with a highly qualified lawyer it will save you more money in the long term compared to paying a slightly lower hourly rate. I would not engage one lawyer for everything but instead get an expert for each topic and use them as needed. That means a lot meetings and time spent on searching for various lawyers but it also means that you will get expert advice for each questions you might have. I would advice against large firms since work will usually be done by junior associates and you will only meet the partner for sales negotiations and billing purposes. Stick with small, specialized firms that know what they are talking about and do not have a deep hierarchy. Also note that lawyers will never tell you yes or no – they will always give you options so that you cannot blame them later on. If you know this, always make them spell out the costs, benefits and problems associated with each option so that you can make a well-informed decision.

Consultants

I am not a huge fan. They will generally tell you what you already know and bill you without mercy. Often an outside perspective can be very valuable but try to get that initially from new employees or hire individuals for specific projects, if you feel you should have an outside perspective. I am very hesitant to believe that someone else knows your problem better than you, if you are truly honest with yourself. Consultants also have the tendency to give advice and to not stick around for the execution of their brilliant plan – they are also not accountable for any of it. Would you work with an unaccountable, extremely expensive employee who does not like to execute? Why should the same not apply to consultants?

Fund raisers and financing partners

As a start-up you will get a lot of requests from these generally well connected senior industry players. They are generally great contacts and very valuable. If you are asked to pay without performance e.g. a retainer or similar up-front payments, I would suggest that you do not work with them. Performance-based pay is the only way to go and it shows that they are confident that they will deliver real value (deals, financing, clients).

eCFO Tips: Remember your consultants/advisors will only be as good as the information you share with them. You should regularly update your advisors and MOST IMPORTANTLY the people who do the actual work on a daily basis (junior staff) at least once every quarter. Invite them over to your company and give them a general update on how things are going. This will ensure that they will provide you with sufficient advice. It will also save you money since advice will generally be better and you will not need as long to bring them up to speed if an urgent matter arises. Throw in some nice food and drinks and I am sure your work will always end up on the top of the pile 😉

Even if you have built a good network of advisors make sure that they can grow with you. From time to time you should review if they still have sufficient scope to giveyou good advice. Sometimes you will outgrow advisors very quickly – you should replace them if it becomes obvious that the relationship no longer works. If you have chosen your advisors carefully and maintained a strong and communicative culture, it is most likely that your advisors will grow with you and continue to be valuable assets throughout the growth cycle of your business.

eCFO Tips: Pricing – often it is going to sound like the hourly rates of your advisors are set in stone. This is not true – make sure that you negotiate not only the hourly rates but also yearly accumulated fees e.g. if you go above EUR50k you get an overall discount on all accumulates fees for next year. In addition, ALWAYS ask your advisors if they are willing to take some risks and enter into a performance agreement. Even if they do not end up doing it, you will find out how convinced they are with regards to actually being successful.

(a) Bankers, accountants, lawyers, consultants, fund raisers – how to deal with eCFO service providers

As an eCFO you will have to deal with a range of different service providers. While making good decisions in this area help you to substantially improve your operations and allow you to run the business effectively, making bad decisions can be very costly to you and your new venture.

I would recommend that you first understand your business well and then look for advisors. You should strategically pick advisors who understand your business and can help you develop it further. As a start-up you should have a good combination of old, reputable wisdom and young, start-upish advisors who will help you to rapidly grow the business. I have selected a few categories of advisors and provided my personal opinion of each. It would be interesting to get some feedback regarding your experience and “best practice for working with start-up advisers!”

eCFO Tips: Always do a beauty contest when it comes to selecting advisors/service providers. No matter how small you are, always have at least 3 potential advisors compete for business. You will learn a lot through these interviews and it will be time well spent. Make sure you also invite people from various background e.g. individuals, small, medium and large firms

Bankers

Find a bank that clearly shows you a road towards obtaining a rating that will allow you to take small steps towards bank financed leverage. Initially, that might mean a conversion of your rent deposit, credit card limit extension and eventually working capital lines. In the beginning you will have a lot of interaction with your banker so make sure you have a personal contact and a strong backup team for daily requests. Secondly, make sure that they understand what you do and offer sufficient support through customized banking software or (in my opinion much more preferable) solid internet banking functionality.

Fees and costs associated with your account should be minimal and waived for at least the first year. Remember you are giving them money and they will not extend any credit to you initially. You should not be paying for giving money to someone.

Accountants

Find an accountant who knows your industry, is extremely reliable and detail-oriented. There should be absolutely no excitement. In addition, it is great if they are looking for new business and are willing to deal with all the additional work of a start-up. An additional great attribute would be a close connection to the regional tax authorities to handle any problems on a personal level. We checked out accountants ranging from one-man shops to the Big Five and eventually settled with a firm that is rapidly growing and has close ties with several start-ups.

From my personal experience I would strongly advice against one-man/woman shows or very small companies. You always need back-up in terms of systems and most importantly in regards to having multiple people who can work with your accounts.  I have seen a case where an accountant got sick and suddenly nothing got done anymore.  In addition, there is also nobody double-checking the work – as it turns out most of the work done by the sick accountant was either incomplete or wrong but this was only discovered after several months by the new accountancy firm and at additional cost. So overall I would recommend that you stay away from small firms and pay a little extra for some peace of mind.

Interesting article “Managing the legal process in an early stage startup” …

Here an interesting article from London based Seedcamp partner Carlos – great read!

Managing the Legal Process in an Early Stage Startup

 

Financing or getting married?

Setting the tone…

Financing is a fundamental decision for each entrepreneur. Unfortunately, there is no perfect financing partner and each financing process should be highly tailored towards an entrepreneur’s individual needs.

I often compare financing to marriage – as crazy as it might sound a financing process has many comparable steps. From the initial flirtatious phase where a person goes out and looks for a date to eventually marry–an entrepreneur’s initial hunt for an investor to the final signing of documents in front of a notary has a lot of similarities. Whether you see your perfect partner on a dance floor or see a famous venture capitalist walking around at a networking event – I promise your heart will start to beat faster. Once a relationship becomes serious and an engagement looms on the horizon an entrepreneur will face a lot of due diligence questions – similar to going for your first trip with the future in-laws. Marriage is just the same – some will be great, long-lasting and highly profitable for both sides, while others will end in a quick and maybe even messy divorce where both sides wish they would have paid more attention to the wedding contract. Most importantly there are a couple of comparable lessons entrepreneurs should take from marriage:

1. Choose your partner wisely – you might be together for a long time
2. Make sure you can live with each other BEFORE you get married – after you signed the contract it is much harder to get out
3. Make sure you have a complementary skillset – as with most marriages your partner will help to mitigate your weaknesses with his strengths and vice versa
4. A good relationship requires hard work, dedication and trust – both sides need to work on keeping the relationship happy

Before going into the more technical aspects I hope that I set the tone for financing and the importance it will have for your venture – it can be a game-changing experience and that is how seriously you should take your financing partner selection process.

This post will now highlight different funding options for entrepreneurs and their new ventures. Aside from all the operational issues the question of a) how much money do I need and b) who should I get it from – are often the most difficult choices an entrepreneur has to face.

In order to define some variables for the case studies below I will show my view of financing stages – there is a lot of debate and options on what stage is what so here are the definitions I found easiest to work with:

Pre-seed:        €0 – €50.000

Seed:               €50.000 – €250.000

First round:    €250.001+

Pre-seed should always be used to get a small test case going that outlines the feasibility of the project and in my opinion this should be 100% financed by the entrepreneur and her team. If an entrepreneur is not able to either raise that amount of capital from FFF (friends, family and fools) she should reconsider if starting a venture is the right thing to do.

eCFO Tips: Especially online focused ventures can easily create a fully functional click dummy, wireframes and a strong web presence to convince investors with more than just nice looking slides. This will help you to move your valuation discussion to a whole new level.

It becomes trickier in the seed financing round. Here the amounts of money needed are more substantial and can often not be contributed by only the entrepreneur or FFF. I would advice to look for a partner in this stage who can contribute more than just capital. This is probably one of the most overused and equally misunderstood statements ever used. 

eCFO side note: my personal favorite and number one overused phrase is: teams – people are everything and I only invest in A team – especially if it comes from a VC or incubator team that replaces its entrepreneurs after every little bump in the road and does not care at all about the entrepreneur who put his blood, sweat and fortune into building a high risk venture. Make sure you check on an investor’s reputation and how past teams of entrepreneurs have been treated.

… more than capital …

More than capital for me means either excellent investor contacts that lead to initial sales, technology knowledge or direct hires. It is often difficult to fully understand how good these contacts are prior to actually using them. Here I would advise the entrepreneur to call at least three different references who can talk about their relationship and experience with the investor. Often entrepreneurs think that ONLY the investor can undertake an in-depth due diligence – this is not true. The entrepreneur should also fully understand whom she is taking on board as an investor and should make sure that her due diligence is thorough.

…sources of capital…

In terms of capital sources I would like to provide three sources of capital that are build on my prior experience and the experience of many other entrepreneurs I have talked to over the years.

Venture Capital

Pros: Venture capital from a professional VC firm or investor is a highly potent source of financing. A VC will, in most cases, have an excellent network and a strong understanding of financing processes. He (and most often it will be a he) is also a specialist in legal and financing documentation. The can provide strategic advice and will have strong market knowledge. In addition, most VCs will have access to either additional capital from their fund or alternatively have a network of financing or exit partners that ensure future capital when an entrepreneur needs to raise more capital.

Cons: For an entrepreneur there is a dark side to all of the previously mentioned positives. VCs will have an excellent network but make sure that the network is right for you – just knowing a lot of other VCs and entrepreneurs might not be what you need. Strong contacts to marketing partners or future clients might be much more important. The strong experience in financing processes and legal documentation is the most frequently used weapon against an entrepreneur. Always remember it is a VC’s JOB DESCRIPTION to write financing documentation that will give him every possible advantage. There is no easier way to completely lose control of your venture than to sign a document drafted by a VC.  A VC will always be better in contracts than an entrepreneur is – remember an entrepreneur is generally operationally focused. A network for follow-up financing and exit partners is exactly that – a quick way to EXIT the investment and get a return. A VC will always want to exit your business in order to get returns. Remember by entering into this financing relationship you are also defining a sale of our business.

eCFO Tips: ALWAYS make sure you understand what drives a financing partner. The average VC will have a three year fund raising cycle that means they have to go out and raise / pitch for new capital one year after closing their current fund. The VC world has become a significantly tougher place – many VCs failed to raise capital during the financial crisis. If an action that puts your venture in jeopardy but will help their fund raising comes up it will be clear what they will do. Be prepared.

They will also have huge return expectations from their capital providers and can only use very limited leverage– so an exit is the ONLY way for them to be successful. Keep that in mind if they ever tell you that they will not push you towards an exit.

Conclusion: VCs have a lot of money available and are highly professional, agile and focused. They will be exit-driven and push you forward as long as you generate returns. They are only in it for the money – never forget that and use it to your advantage.

Joint Venture / Strategic Partner

Pros: A joint venture with a strategic partner can be a great thing. A strategic partner will have deep operational experience and in most cases significant non-financial assets. Aside from capital this partner will often offer access to clients, knowledge and team members that a budding entrepreneur could never source independently. In addition, it will be a strong financing partner who is not discouraged by small bumps in the road and is in it for the long-term.  An entrepreneur can also be sure that the right exit partner has already been found. Most strategic investors will add a call-option to the financing document that allows 100% purchase of the business in the future.

eCFO Tips: Call-options are funny things – you are giving away your company at some point in the future without having any indication, beyond wild hopes and dreams , of its value at the time of exit. Remember that in general there are some things are just as true for a strategic partner in the future as in the present– they will still have more lawyers than you do, they will hopefully still have a substantial strategic interest in your company and they will have cash.

So try to lock in a valuation method now that rewards you for parameters you know your business can potentially reach. As an example: don’t put an EBIT based valuation into the contracts if you know that you won’t reach break even for a while or agree too easily to a “at fair market” valuation. Especially with fair market value valuations it will be hard to argue for a correct market value if this asset makes only strategic sense to your individual investor and when you have no realistic way of shopping / showing your company around to other investors when you are trying to exit. Even if you put in the popular phrase that allows for an evaluation of an independent auditor remember that this auditor will most likely be working for your strategic investor and that they will always be a more interested to work for the strategic in the future than you – magically that can influence valuations!

Cons: Again, what is true for VCs is true here as well. Most of the pros of a strategic investor can be turned around into negatives. Most of all, be prepared to be in it for the long-term – that is true for EVERY SINGLE ASPECT of this relationship. In the beginning be aware that most strategic partners will have decision making processes that make a snail seem to move at rocket speed. From the first pitch to actual investment it can easily take 9-12 months.

In general, strategic partners will also be huge organizations – getting to the right people at the right point of time and piercing through inter-corporate politics can keep you quite busy. In a start-up there is no time for politics and things that move you ahead in large corporations. Things like number of employees (overblown teams), budget (spending & wasting) ability and political connections (sucking up) will actually be disadvantageous for any start-up.

You will also not be able to move in any direction you want. Certain clients, business methods and entrepreneurial shortcuts will be off the table. The strategic partner will also be sure to keep the upper hand in any contract and it will sometimes be hard to show that this is a joint venture between equals.

Conclusion: A strategic partner can unlock assets that you couldn’t buy with money – contacts and operation experience can be right at your fingertips. It will be generally a lot nicer relationship than with your average, cut-throat financial investor but you will have to deal with a lot more politics, size and slow- moving operational structures.

Bootstrapping

Pros: For me this remains the true key entrepreneurial discipline. There is no better feeling than growing a company based on the strength of your team and your personal efforts. Almost nothing feels better than looking at your financials and generating substantial returns and knowing that all it took was your hard work and not somebody’s capital. You did not buy your success – you truly built it.

Aside from this motivational aspect it also means that when it comes to making decisions you do not have to ask anyone else. Your team and you have full freedom to run the business. It also means that you can grow a business and maintain ownership of the business as long as you want. This is also true for all returns that your business generates.

As an entrepreneur this also prepares you for making hard and fast decisions. You do not have time for waste of capital, bad employees or unprofitable clients. You have to act quickly and decisively to stay alive since there will be no capital buffer to keep you going if you run out of cash.

Cons: Bootstrapping is hard, often prevents you from making necessary investments and always distracts from the operation side of your business. It is also only good for highly cash-generative business models such as services provider and agencies. The constant liquidity pressure will also shape you as an entrepreneur and make you hesitant to go on sometimes necessary spending sprees and/or investments.

It will put your team into a hard place that often requires to opt for short-term cash generative measures instead of focusing on long-term value creation.

Conclusion: Bootstrapping stands for freedom from external investors but puts severe operational restrictions on your business. It can only work for some business models and will make it almost impossible to quickly expand your business or to rapidly capture markets. For me this remains a key test of your entrepreneurial skills but most people will not be able to build a significant business without any external capital.

…and finally

In our business we have successfully raised capital and grown businesses using all three of the above mentioned financing methods.  That taught us that there is no perfect financing partner but depending on which venture you are trying to get funded one or the other will be a significantly better choice. Just make sure that from the get-go you understand your motivation and what motivates your financing partner. Any relationship then needs hard work, dedication and trust. Make sure that all three of these aspects are maintained throughout your financing partnership … come to that and going full circle from the beginning it might even help in private partnerships as well 🙂

Quick Disclaimer: I have only focused on equity capital. There is a lot to be said for alternative financing or debt financing. Stay tuned for a discussion of these topics at a later stage in this blog.