A VC friend emailed me the following question(s) a few weeks ago:

The rumor this week regarding Yahoo acquiring Digg for $30M sparked a discussion here around company valuation. The discussions revolved around the key factors in valuing an early stage web technology business and how these factors are being evaluated by investors today. For example, would Yahoo or other companies be buying the technology? Are they buying subscribers? Are they buying a brand or is it a weighting of a number of these factors? Based on what you are hearing, how would Digg, Technorati, livemarks or another consumer internet business be both evaluated and valued today?

Remember the Jedi Mind Trick that goes as follows:

Stormtrooper: Let me see your identification.
Obi-Wan: [influencing the stormtrooper’s mind] You don’t need to see his identification.
Stormtrooper: We don’t need to see his identification.
Obi-Wan: These aren’t the droids you’re looking for.
Stormtrooper: These aren’t the droids we’re looking for.
Obi-Wan: He can go about his business.
Stormtrooper: You can go about your business.
Obi-Wan: Move along.
Stormtrooper: Move along… move along.

I recommend my VC friend meditate on it.  There’s been plenty said in the blogosphere about Web 2.0 companies, the notion of “build-to-flip”, the AGILEAMY gang looking to buy early stage technologies / features to plug into their platforms, and the need to transform / reform / change venture capital to accommodate these companies.  I won’t retread those discussions here.  However, I will add two things.

This is not the real VC game: While there is a category of VC firms that is deliberately looking for companies that are planning on raising a small amount of money (< $2m) and then selling quickly to AGILEAMY, this is a game best left to angel investors.  The ratios are bad (1000 companies created for every one acquisition), the upside is too small (even 10x a $2m investment – which is probably the best you could imagine – is not worth the risk / reward ratio), and ultimately there becomes fundamental tension between the VC (who wants to build) and the entrepreneur (who wants to flip).

This is a dangerous long term approach for any VC investor: Repeat after me – “there is a very limited amount of easy money.”  There’s some – but VC firms (and successful VC investments) are not made on easy money.  It’s definitely like candy – it tastes good in the moment, but isn’t particularly filling or long lasting.  Taking a great new idea with an entrepreneurial team that wants to create something significant and trying to build a real company is what is interesting.  Unfortunately, VCs will habitually over invest in new, trendy areas.  As a result, companies that have a clever product idea but don’t have a long term vision for a business will end up with $5m to $10m in the bank and the pressure to “grow.”  However, they’ll have no where to grow to – they should be small, scrappy, underfunded companies focused on trying to beat the 1000:1 odds and end up with a flip.  Once they’ve raised $5m+, they are on a different trajectory and – if in 12 months they haven’t turned their nifty product into a business – life can get really unpleasant for everyone involved.

Fundamentally, if you are a VC, these aren’t the droids you are looking for.  The same is true for the entrepreneur – be wary of the droid you pick.

Last week, I blogged an answer to the question “What’s The Best Corporate Structure For An Early Stage Company?“  A few people responded asking why I didn’t like LLC’s more.

While there are several advantages of an LLC over an S-Corp (ability to issue different classes of securities, ease of set up, informality of operating agreements, lower state taxes, non-US investors), venture funds typically cannot (or don’t want to) invest in LLCs.  When a VC invests in an LLC, they risk getting an income tax called UBTI (unrelated business tax income). This type of income is frowned upon by investors in venture funds partnerships and most funds have a provision in their fund agreements that they will use best efforts not to bring UBTI into the partnership. As a result, VC funds shy away from investing in LLCs.

The able minded entrepreneur says “yeah Brad, but I’m not ready for venture capital yet – I’ll just do an LLC now and convert to a C-Corp when I raise VC in a year.”  Ok, but in order to “convert” an LLC into a C-Corp, one actually has to go through a complete merger, whereby a new entity is created, which usually drops down a wholly owned subsidiary, that sub is merged into the LLC, leaving the LLC as the sub of the parent. In short, it’s complicated and makes the lawyers and accountants some extra cash.  Yuck.

In contrast, converting an S-Corp to a C-Corp is simply a “check the box tax election” (or – actually – “unchecking the box”) – this can be done in a day with a single tax form.  No lawyers, no accountants, no money.  Therefore, while the LLC has some benefits, the costs of converting the LLC into a fundable entity is substantially higher and usually not worth the additional effort.

My dad and I spent the last two days hanging out together in San Francisco.  We try to do this once a year – just the two of us – exploring a different city together.  This year we picked a perfect weekend – the weather in San Francisco has been incredible.  We stayed downtown in the Hotel Vitale – an ideal location right on the edge of the Embarcadero Waterfront. 

We spent Friday afternoon wandering around, followed by dinner at Lime and a semi-private viewing (e.g. surprisingly few people) of Firewall at the Metreon.  We both went running early this morning followed by another day of museums and a great dinner at A16.

We started the museum thing yesterday afternoon at the San Francisco Museum of Craft & Design.  They were between exhibits but let us wander around because I mentioned my friend Wendy Lea’s name (Wendy is one of the founding members of the museum.)  It turns out my membership expires in a month so I used the opportunity to delay my expiration by another year.  I’ll have to swing by again before May 29 to see the “Textile Art in the 21st Century” exhibit.  Since we hadn’t seen much art, we ducked into a few galleries – the memorable ones were the Himmelberger Gallery and the Caldwell Snyder Gallery – both on Sutter Street.

After an awesome run on the Embarcadero, we started our day at the Crown Point Press.  Amy and I collect several artists that Crown Point represents (such as Christopher Brown), as do my parents.  However, I was really disappointed this visit.  The exhibit space was sparsely populated and the artist (who’s name I don’t remember) wasn’t memorable.  Oh well.

SFMOMA (The San Francisco Museum of Modern Art) was up next.  I love this building and the museum never disappoints.  The Chuck Close Self-Portrait retrospective felt a little meglomaniacal, but it was intriguing.  The 1906 Earthquake photography exhibit was great – it’s a superb perspective on how fragile the city actually is in the face of a major earthquake.  SFMOMA – as it often is – was one of the highlights of the trip.

We finished the day by taking a cab over to Golden Gate Park to take a look at the de Young.  The building – created by Herzog & de Meuron – looks amazing in photos.  Unfortunately, in real life I thought it was much less impressive.  I might be jaded by the new Denver Art Museum by Liebeskind – which is an incredible work of architecture – but I was disappointed by the de Young.  The trip up the de Young Tower to the top of the building was ok – the views of the city are great – but was also overrated.  The overall collection is a total hodgepodge of stuff.  The museum tries to make sense of it and rationalize the collection, but I thought the descriptions (and the art) missed the mark. 

Dad – thanks for the great weekend!

Last week I was disturbed by the announcement that AOL was going to eliminate their enhanced whitelist.  It was reported that they were doing this as part of a new program they were implementing to provide a pay-for-access program for mailers using Goodmail’s stamp program.  I’m indifferent to AOL providing Goodmail’s stamp program as an option (the market will determine whether or not it works), but I thought it was a horrible idea to eliminate the organic enhanced whitelist and force all mailers to use the stamp program to pay for access to consumers’ email inboxes. I expressed my opinion publicly and forcefully (oh – the joys of having a blog that more than two people (me and Amy) read.)

Charles Stiles from AOL commented that night on my post that “AOL will continue to offer IP-based white list and enhanced white list privileges to mailers that do not wish to take advantage of the CertifiedEmail program. As long as there is market demand and operational need for these services, AOL will continue to operate them.”  There continued to be plenty of confusion and contradictory information in the market, based off a “confidential document embargoed until January 30th” that stated that AOL would eliminate the enhanced whitelist on June 30, 2006.

Matt Blumberg – who runs Return Path (a company I’m an investor in) – finally connected with Charles Stiles on Monday – and confirmed that AOL is keeping the enhanced whitelist and has no plans to eliminate it.  This addresses the fundamental issue that I expressed in my post.  While I continue to think that allowing mailers to pay for access to the inbox is a bad idea, as long as ISPs provide an organic option for mailers to earn their way through consistently good behavior into the inbox, I’m happy.

It doesn’t really matter whether AOL reversed a decision or the initial press interpretation was incorrect.  What matters is that AOL has been thoughtful about this and is choosing a customer-friendly approach to keeping the bad stuff out and letting the good stuff in.  I felt it was worth publicly acknowledging that as a bookend to my initial reaction to what was announced.  AOL – thanks.  Yes Jason – I’m happy.

279: Own Your Mistakes: FeedBurner screwed up the other day.  One of the new guys on the publisher team sent out a generic, unsolicited email to about 90 people who aren’t FeedBurner publishers.  While it’s arguable about whether or not it was spam, it was bad form, stupid, and not FeedBurner’s style.  There was some immediate chatter about it from a few of the people that received the emails and rather than defend it, Dick Costolo (FeedBurner’s CEO) immediately commented on each post he saw saying “we screwed up – we’re sorry” and then put up a public apology on the web site later in the day.  Every company (and everybody) makes mistakes regularly.  Acknowledging them immediately, apologizing, correcting them, and learning from them is less common.

280: Our New Investor: Fred Wilson from Union Square Ventures posted the other day about Why USV Invested in FeedBurner. I’ve known Fred since the mid-1990’s and have worked and invested with him in a number of companies.  Fred’s actually the guy that introduced me to FeedBurner a few days after I started blogging in May 2004.  When I led the last round in FeedBurner, I was working on it with Fred – he describes in his post why he and his partner Brad Burnham decided not to do the financing with me at the time.  However, they continued to help FeedBurner and Fred often said that FeedBurner was “the company he worked hardest for that he wasn’t an investor in.”  Six months later Fred and Brad realized they made a mistake by not investing, owned it (see #279 above), and approached Dick about investing.  While FeedBurner has regularly been approached by investors expressing interest, the company has no near term need for additional capital so we’ve simply passed on exploring it with anyone.  However, Fred and Brad had done so much work for the company, had built a personal relationship with Dick, and were unquestionably able to add significantly to the group around the table.  It didn’t take long to reach a deal that everyone was excited about.  Welcome Fred and Brad.

281: It’s a Platform: I love FeedFlare – it’s a supercool new FeedBurner feature.  FeedFlare by itself is plenty, but like every good company that is building out a platform, FeedBurner announced the FeedFlare Open API today.  Now anyone can write their own FeedFlare’s – the nice people at FeedBurner made a list of 101 different ones that they’ve thought of already in case you are inclined to write a FeedFlare.  Look for FeedFlares to start proliferating.

As regular readers of this blog know, I’ve been having a lot of fun with Tom Evslin’s blook hackoff.com.  Several weeks ago, I got on a conference call with Tom Evslin, Matt Blumberg, Kelly Evans, Stephanie Miller, and Fred Wilson and recorded a scene in the book.  Tom put it up on the hackoff site today in two segments: here and here.

I played Joseph Windaw of Windaw and Wallar Venture Capital, a very white shoe VC who has a lifetime pass to the Harvard Club.  As a jewish kid with a couple of degrees from MIT that wears sneakers, it was a tough role for me but Tom said I pulled it off fine.  The balance of the cast is described in detail on Tom’s post about the recording.

The production quality was surprisingly good considering we did it over Skype and cell phones.  I’ve suggested that we all hunker down for a three day weekend in New York and crank out the entire book in a real recording studio.

It’s been a while since Jason and I wrote an entry for our Letter of Intent series.  Yesterday, as I read through a confidentiality agreement that I had been asked to sign, I was inspired to address another typical part of an LOI – the dreaded confidentiality / non-disclosure agreement.

While venture capitalists will almost never sign these in the context of an investment, they are almost always mandatory in an M&A transaction. If the deal falls apart and ultimately doesn’t happen, both parties (the seller and the buyer) are left in a position where they have sensitive information regarding the other. Furthermore, it’s typically one of the only legally binding provisions in a LOI (along with choice of law and break up fees.) Everything else is dependent upon the deal closing. If the deal closes, this provision largely becomes irrelevant since – well – the buyer now owns the seller.

The good news is that both parties should be aligned in their desire to have a comprehensive and strong confidentiality agreement, as both parties benefit. If you are presented with a weak (or one-side) confidentiality agreement, it could mean that the acquirer is attempting to learn about your company through the due diligence process and may or may not be intent on closing the deal.

Generally a one-sided agreements makes no sense – this should be a term that both sides are willing to sign up to with the same standard.  Public companies are often very particular about the form of the confidentiality agreement. While we don’t recommend sellers just sign anything, if it’s bi-directional you are probably in a pretty safe position.

I took the day off and played with my friends.

Some of the places I hung out in were “above the action.”

I got to hang out where the president struggles with the weight of the worldly issues that he doesn’t really want to deal with.

I can’t tell you much more about it – you’ve read my file, you know what I’m capable of.

Congrats to my cousin Jon Feld, his business partner Todd Price, and all the folks at Navigator Systems – they announced on Friday that Navigator Systems has been acquired by Hitachi Consulting. 

Jon and Todd started Navigator Systems 15 years ago.  At the time, I was running Feld Technologies – my first company.  I remember a seminal discussion in my grandparent’s garage in Florida when Jon told me that he was going to leave Frito-Lay and start Navigator.  At the time, Jon was a Lotus 1–2–3 stud so I hired Navigator (for one of its first contracts) to do some Lotus 1–2–3 modeling for one of our law firm clients.  I hope Jon still has the invoice he sent me – that’s definitely something that should end up in a frame on a wall somewhere.

Navigator was an early pioneer in providing “business intelligence” consulting before anyone really had defined “business intelligence” (and yes – I know you Dilbert fans will still consider this phrase to be an oxymoron.)  We shared an early client – Mittler Supply Company – where Feld Technologies provided the custom software and Navigator provided the business intelligence consulting.  Mittler was a large, multi-location industrial gas supply company headquartered in South Bend, Indiana.  Jon and I spent a lot of time there (yet I was never alert enough to go see a Notre Dame game) wrestling with an AS/400 based accounting system, a set of Clarion applications to transform the data, and a FoxPro application to let the Mittler folks play around with the resulting data warehouse.  All of this was well ahead of its time, but I’d like to think we helped Mittler a lot over the years – they were good people.

Navigator has been very successful over the years, making the Inc. Magazine 500 Hall of Fame (for being on the Inc. 500 list five years in a row.)  Navigator was largely self-funded and – although they did take a small mezzanine debt round around 2000 – and should act as an inspiration for all of you entrepreneurs out there that don’t want to take VC money.  Jon and crew have been approached numerous times of the years about being acquired – they were patient and only chose to go forward when the deal on the table was great for all involved (in this case, including Hitachi Consulting who just added a superb company to their portfolio.)  I’m proud of Jon and team – congrats!