Most first and second pitch meetings with VCs are fairly lopsided, where entrepreneurs spend the bulk of the time sharing their businesses, rather than being a true exchange of both parties in developing a relationship. However, there is typically (and should be plenty of) time for founders to ask VCs questions about their approach and working-style to help determine if there’s a mutual fit.
Somewhere in the past few years a meme developed that a sophisticated best-practice question to ask a VC in early conversations is something like “Where are you in your fund’s investment cycle?” The idea is that if a venture firm is towards the end of its capital availability that they’re much less likely to invest in a new startup, and that there are even cases of “walking dead” firms taking entrepreneur meetings to maintain the appearances of being “in market” with very little intentions (or ability) to invest at all. These situations are certainly prevalent and therefore entrepreneurs need to be cognizant to avoid spending too much time with a venture firm where the end result of the conversations isn’t going to be fruitful. However, it’s rare that a venture capitalist is going to point-blank admit that his pockets are empty. There are too many ways to answer the question above without really addressing the heart of the issue: the likelihood of making a new investment. Because most venture capital firms reserve the bulk of their capital for follow-on investments, and a smaller portion for initial investments, it’s not difficult to spin the numbers to tell a story since about how there is still a pool of capital available… except it’s earmarked for something else. Moreover, the situation is more nuanced – given that some firms at the tail end of their fund have confidence in the ability to (or have already been able to) raise a new fund, whereas others do not, being at the tail end of fund isn’t necessarily a bad thing. Or it can be especially negative if a firm changes its strategy toward the end (like investing in a number of seed round with about capacity for any follow-on). It just all depends.
A little simple homework can rule out asking the question altogether. Nearly all VC firms follow an initial three year initial investment cycle on a ten-year fund life (with the possibility of extensions). So if you’re meeting with a firm which has raised a new fund within the past three years, it’s pretty safe to say there is available capital for new investments. A simple Google search can usually yield an answer, and it surprises me how many entrepreneurs fail to do this before asking about the fund’s investment cycle in a meeting.
Once a venture fund’s life is entering the fourth year and beyond, the situation can change. In this case, the best way to determine future behavior is to look at recent behavior and use it as a proxy. The better question to ask is: “When was the most recent new investment your firm made which had the size & shape of the one which we’re seeking?” Often you can fund this information on the web (like on Crunchbase) anyway, but sometimes, and especially with seed investments from larger firms, not always. A venture firm has a tendency to slow down towards the end of its initial investing cycle, rather than coming to a sharp halt, so the longer since a recent investment of the same profile, the less likely the capacity and willingness to add another investment. It seems as though there’s always room at the end for potentially one more investment in a fund, so venture capitalists always like to keep the door open, and may feel given that fact it’s not disingenuous to do so. So in the end, the grey area of a fund’s initial investment period end is going to be opaque at best. It’s productive then for entrepreneurs to play detective to ensure that they don’t waste their time on conversations with firms without the capacity to invest, but also to be realistic about the clarity of the answer uncovered.
Brian Halligan had a great post up last week about the lessons learned from raising a mezzanine round of financing. It’s really interesting, but perhaps only applicable to a more limited set of entrepreneurs. However, there was one gem of a small section in there with a more widely acceptable takeaway:
“It turns out that the terms from your Series A are most often cut and pasted into your later round deals. When you compromise on terms in the early stages, you will have to pay the price in the later stages. You generally don’t start from scratch and rehash the terms.”
As a seed stage investor here at NextView seeing our companies progress down fundraising paths, I think it’s extremely important to highlight that terms in early rounds do set precedent for terms going forward. And that’s not just for Series A deals; this phenomenon starts even from a Seed round.
One could cite that the reason for this behavior is pure laziness, as Brian alludes to in a “cut and paste” mentality of later investors. But the more meaningful reason that early financing terms endure into future rounds is that negotiation away from terms already in place are just that – negotiation. In other words, new investors must use their leverage in the discussions to proactively change those pre-existing terms rather than focus on price, new terms relevant only to this deal, or other aspects of this specific round where they have an interest in influencing (like syndicate composition or allocation). And even when that’s possible given the situation, the old terms provide an anchoring point for all new terms to be referenced against, so they don’t end up straying too far except if there’s a real meaningful reason for them to differ.
Given that this phenomenon is fairly pervasive, I think that there a number of takeaways for entrepreneurs who are raising early rounds of capital:
- While valuation is the most salient point in a deal and certainly important, terms matter quite a bit and A LOT more than most entrepreneurs pay attention to. Terms don’t start as in-your-face numerical figures… but they do end up that way when it comes time to exit.
- Earliest terms matter most, even and especially in the seed round, because they set not only the base literal structure, but also the “tone” for future financings. Once there is punitive-looking round, the more likely the company will be a punching-bag on terms in subsequent rounds moving forward. In contrast, valuation always has room to move up.
- Terms precedent is one solid reason (among others like founder-investor alignment) that entrepreneurs should have bias towards priced equity round vs. convertible notes in seed financings. While the intent of notes is often to delay setting a valuation until context is more crisp, kicking the can on terms can be dangerous. It’s preferable to set them early as possible when investors are most accommodating as in seed round (because they too have incentive for clean terms without bells & whistles which could eventually hurt them as well).
Yes, early terms endure. It makes sense then for everyone involved with early financings to consider not just the deal at hand, but also what it means for the future.
There are a couple classic archetypes of internet/software founders, including the genius college student cooking up something quirky but ultimately disruptive in his dorm room who launches his company straight out of undergrad. But the other archetype is a thirty-something entrepreneur who, taking his experience seeing the playbook of success at larger growing startups or even “established” companies, utilizes that domain and functional expertise as unique insight into founding a company. This latter persona is still hungry, but is able to really leverage that experience-set.
While a year ago there was much ado in the blogosphere about the peak/best age of an internet entrepreneur – whether it’s someone under 30 with fresh de novo thinking – there is some statistical support that the successful thirty-something entrepreneur is actually more prevalent. Anecdotally, you can point to examples here as well (Zenstrom / Skype, deWolfe My Space, Hoffman / LinkedIn, Williams / Twitter were all in their thirties). In reality, there is no “best” age to start a company, but rather different cohorts produce different profiles of entrepreneurs and resulting companies. (And at NextView Ventures, we’ve funded both young entrepreneurs out of college as well as veteran executives in their forties, along with a range in between.)
One historical challenge with the Boston entrepreneurial scene is that while we have a continually refreshing supply of the nation’s brightest coming out of our local prestigious educational institutions, for the better half of a decade in the 2000’s we were both losing people coming out of school, plus we had fewer of the second set of thirty-something internet entrepreneurs referenced above. Two years ago Jeff Bussgang lamented about “Lost Generation” of entrepreneurs which I think is especially acute here in Boston.
My own personal story fits in with this narrative. I was in my early 20’s just barely out of school when four of us (peers) started Sombasa Media (aka BargainDog) here in Boston beginning in 1998. We rode the bubble wave to a successful outcome in 2000, and after moving away for a few years which included a stint at business school, I returned back to Boston in 2004, and it felt like the web entrepreneurial community had almost entirely scattered after the crash. Reactions when I told people I was an “internet entrepreneur” ranged from smirks to blank stares.
In only a few short years, the strong pillars of the local Internet scene, like Lycos & CMGI (+ affiliated companies), had fallen away and been rendered irrelevant. Along with their demise came a dismissive attitude about most entrepreneurial web-related endeavors. It surprises me how little this fact is talked about in Boston, but there was a vacuum left behind with these potential powerhouses withering away. If you had a few ounces of entrepreneurial blood in the late 90’s, of course you started an internet company (for better or for worse). But from the middle of the last decade onward very few peers of mine were starting companies because they hadn’t had the opportunity gain that valuable experience like they would have had at Yahoo then Google on the west coast -or- they were dissuaded from negative experiences during the crash and a challenging atmosphere after. Instead, they had fled to other industries and those other geographies. My own motivations for starting the Web Innovators Group in 2005, and the reason I believe it took off so quickly, is that there were relatively few people in the community, but those who were all yearned to congregate and find a similar network of like-minded individuals.
Today the landscape is very different from 2004. First, there is an organized community net which is better (although certainly not perfect) at “catching” raw entrepreneurial talent out of the universities and keeping people here in their 20’s. Recent initiatives like Startup School are easy examples to cite, but there are numerous programs including the proliferation of networking events which have laid an infrastructure support to help keep the next Zuckerberg from slipping through the cracks. But second, we’ve also had a number of internet successes which have trained and developed people (e.g. TripAdvisor, Brightcove, Constant Contact, Wayfair) over the past few years where employees are beginning to roll out to start new ventures. And the larger imports (Microsoft, Google, eBay… recent challenges not withstanding) have now been established for a time that people have had at least a few years to formally train in internet software product development areas. And so that second cohort of thirty-something entrepreneurs is just now emerging as a solid group because there have been places for the internet skillset to develop. For example, it’s much more prevalent today in 2012 to have been a tactical internet marketer for the past five years whereas in in 2007 is just wasn’t. There is also now a third cohort, though still rare, of awesome people who have had entrepreneurial success experience during the 90’s boom now building truly transformative companies later in their careers who had moved away & returned, who eschewed a venture capital role after a brief stint, or who had been doing it all along. Plus, on top of it all, with accelerator programs we’re net importing kick-ass founders from all over the world. But last of all, attitudes have changed – you CAN build a great internet company here in Boston, and we have a community which sincerely believes it.
So in Boston, it’s essentially taken a decade, but we’re finally overcoming the crater that the failed local internet giants left behind after the 90’s bubble. There are now three strong cohorts of internet entrepreneurs ripe with ideas & passion who are deliberate about staying here & building the center of the universe for emerging platforms. And that certainly wasn’t the case when I moved back here in 2004. With real clusters of strength in areas like mobile, marketing, and consumerized B2B SaaS – Boston is entering a golden age of internet entrepreneurs positioned for the future.
A few days ago, a friend who works at a growing startup emailed me with the following question (in which I’ve masked just a few of the identifying details):
- I caught up with a friend of mine from high school that has started a new company where my skills are very pertinent. He wants a data scientist to come do some work for them, and while I’m intrigued, I’m not ready to jump ship and join them 100% of the time. I am, however interested in throwing 20 hours a month into helping them out, possibly helping them recruit some talent when/if they need a full time analyst, etc. We’re close to formalizing some sort of relationship.
- Here are 3 questions that come to mind: 1) We’re using this document from the Founders Institute as a template and guide for comp. I’m curious if you think this is ballpark okay. 2) Are there any risks to serving as an advisor that I might not be thinking about? 3) Any other advice or experience with advisory relationships? I’m definitely not in the rainmaker category that I think a lot of young companies look for… in the short run I’ll be more like a part-time employee than an advisor, but expect that will change if the company moves forward.
My email response to his question was:
- On your questions below, it sounds like a good situation. You’re able to spend time with the company during its early stage to do some interesting work, explore if there’s a good fit for you there in the long run, and be compensated for the efforts which you’re putting in. The compensation framework and contract template are reasonable (though of course I am not a lawyer).
- But broadly speaking, I think that there are two risks/issues to be thinking about. The first is around your eventual role/compensation if you’re likely going to join full-time. Spending 20 hours a month is fairly significant amount of time. If in a few months or a year, you decide to take the leap to 100%, you’re of course want to negotiate an equity relationship which is more appropriate for that role. Unfortunately, your equity is already going to be anchored <1% depending on where the company is today. At that time, you may not have as much leverage (with the company or whatever their current/future investors) to meaningfully increase that amount to the same level where you would have come in if you started the conversation today about equity comp commensurate with a start working part-time yet with a specific path to full-time. The risk is that you’ll look back having put in meaningful time into the company and all-in not feel like whatever additional package they can offer you is worth it. Yet you might not want to make that personal commitment/signal today, which is also reasonable. The closer this role is to a part-time co-founder versus a later employee, the more acute an issue it is.
- The second risk is a contractual + relationship issue with your current employer. Depending on what you signed when you started your job, you may be prohibited from moonlighting, or at least required to disclose it. It’s up to you given the overall situation and your own point-of-view if you want to share this role with them. I think the worst-case scenario would be one where you eventually join this startup and your current employer finds out that all along you had a (potentially violating) contract in place with this startup and then jumped ship to them – they may not take kindly to that. Again, it all depends on your relationship and how you manage information.
After completing a long process identifying the right venture firms to pitch, running an exhaustive fundraising process, finding a mutual fit, and successfully negotiating terms… at last, the term sheet is signed. So at this point it’s OK to just hand the process over to your lawyers, sit back, and let them work out the details, right? Wrong.
The two- to six- week time between the signing of the term sheet and closing is “venture limbo.” At this point, entrepreneurs know who they’re going to be working with and along what structure, but the deal isn’t done yet… including wiring of the funds! Most of this time-period is taken up by lawyers drafting and then negotiating the finer legalese points of the full set of legal documents. But it also includes legal due diligence, rounding out the round with additional syndicate investors (often angels in seed rounds), figuring out allocations, as well as sometimes even (but hopefully not) additional business diligence for the institutional venture investors.
The problem is that time kills all deals. The longer this limbo period extends, the more risk is introduced that the process will veer off course or even fall apart entirely. It should feel like things are accelerating towards a close, as opposed to marching along at a steady pace; and it certainly should not feel like deceleration towards the end.
The possibility of negative scenarios adversely affecting the outcome range all the way from some uncontrollable exogenous disastrous macro event (of which there have been a few major ones in the last dozen years) to the possibility of a venture firm simply getting cold feet and backing out. Obviously, only the latter is within the locus of control of everyone involved. It doesn’t matter the reason – a competitive funding announcement, a customer loss, a bad month of results – with more time, the increased chances of more emerging mitigating factors to getting the deal completely finalized. And even if the relationship with the VC partner leading the investment seems solid, entrepreneurs have little window into his partnership political dynamics during that time which could force him to lose his hold on pushing the commitment over the line.
What can extend the month of limbo? Lawyers going back and forth on minute/inconsequential details, of course. But frequently, there is time spent negotiating business terms which weren’t specified in the tern sheet itself. Founder vesting is the most common example. Or sometimes VCs renegotiate terms or introduce new concepts – nefarious, but I’ve seen other firms exerting their negotiating leverage in a relationship given this situation. And I’ve seen weird unpredictable situations crop up that delay things, too. As an extreme but real example, once a standard background check which was run on the startup’s CEO reported that someone with his exact name from his exact town was a felon convicted of embezzlement. It turns out it was literally the wrong guy, yet same name / different person, and the entrepreneur was asked to sign an affidavit maintaining it wasn’t him. But the whole cycle delayed the closing and almost derailed things because of the uncertainty.
The good news is that these scenarios don’t happen often. At the end of the day, a VC signs a term sheet for a reason: they’re making an agreement under the circumstances which they’re eager to do. The job of the entrepreneur is to ensure those circumstances don’t change too much in the interim. And most VCs (including all of us at NextView) pride themselves on their reputation about keeping their word, not backing out of term sheets or renegotiating after they’ve been signed. But the takeaway here is that the fundraising process isn’t complete until the money is in the bank.