Category: Term Sheet
My friend Paul Kedrosky – who spends some of his time as a Senior Fellow at the Kauffman Foundation – has a thoughtful short video (as part of the Kauffman Sketchbook series) on where entrepreneurs get their money. While it’s easy to get confused and think that VCs are the center of the financing universe, Paul reminds us that most entrepreneurial companies are funded by the entrepreneur’s savings, cash flow, credit cards, friends, and family.
It’s a creative three minute video with plenty of meat to it.
I recently spent some time with a long time friend and entrepreneur who I’ve funded in the past. He’s working on a new company which I think is really neat and I’m already a user of. He called me for feedback on his fundraising strategy as well as to see if it’s something that we’d be interested in investing in.
It’s outside our themes and different than the type of business we invest in. Given our long relationship and the fact that he’s an awesome entrepreneur, I squinted hard at one of our themes, turned my head sideways, and decided to take a look. We spent a few days applying our process to it (each partner touches it and we give each other real time qualitative reactions) and quickly realized that it really wasn’t something for us as it was far outside anything that we felt like we could help much with beyond money and moral support (which my friend is going to get from me anyway.)
So – I sent my friend a note with my explanation for why we are passing. I offered to help with introductions because (a) he’s an awesome entrepreneur, (b) it’s a very fundable business – just not by us, and (c) I have a lot of confidence that he’ll build a successful business and there are several VCs who I know that I think would like what he’s working on.
His response was dynamite. It was
“No sweat. I knew it was a longshot, so I appreciate you even considering it. I know how many deals you have to pick from.
I’d like to take you up on your offer to help us get funded, but I have a better idea … help us avoid the need for funding (700 clients gets us to profitability).”
He then went on to detail a handful of things he’d like me to do assuming that I’m a happy user of his product. All of them are easy, low maintenance for me, and in several cases actually benefit me.
I love that my friend is much more focused on ramping up his customers than raising money. It’s easy to get lost in the soup of “X company raised $Y” and forget that it’s not about fundraising, but building a business. When I think of some of my favorite TechStars companies, such as Occipital, they bootstrapped for several years before raising any money (well documented in the book Do More Faster) and even then could have easily built their business without raising any money.
Don’t forget to bootstrap.
For some time Jason and I have felt that VC’s have had an unfair advantage when it comes to understanding term sheets. So a few years back we wrote a whole series of blog posts (the Term Sheet series) which became the basis for the book Venture Deals: Be Smarter Than Your Lawyer and Venture Capitalist. Our goal with all of this was to help put entrepreneurs on a more even footing in negotiating a deal with a VC.
In some ways, I’ve always seen writing (both books and this blog) as a form of personalized teaching. It let’s me efficiently share whatever knowledge I have. But a few months back while I was visiting TechStars NYC, I had the chance to meet the guys over at Veri and pretty quickly realized they have a really interesting format for teaching things like how a term sheet works in an even more personalized way.
The result is Veri’s Understanding Term Sheets. The experience works like it would if we were learning it together one on one, namely that I ask you a series of question to figure out what you do and don’t know. When you know the material you get to quickly prove you’re a champ. When you don’t know something, I help bring you to the exact snippet of information you need to know. In other words, we figure out what you know, and help you learn only what you don’t. And hopefully have some fun in the process.
Let me know you think about Understanding Term Sheets, especially if there are ways to improve it.
While Jane was building SayAhh’s revenue projections, Dick focused his attention on building the expense side of the projections. He procrastinated for a few weeks because he was deep in product development, but surfaced a few days ago when he realized they had an investor meeting coming up and really should have at least a basic financial model ready in case the investor asked about it.
Before building his projections, Dick needs to make three main decisions:
- Should he build a simple cash forecast or a set of projected financial statements?
- What are the right drivers for each expense category?
- How should he account for unforeseen expenses?
1. Cash Forecast vs. Projected Financials – What’s the difference?
A simple cash forecast is just that – it is a model that helps anticipate cash balances over time. It is simple in that it forecasts how much cash will be coming in the door (revenues + equity financing + debt financing) and then subtracts from that amount how much cash is expected to be going out the door. The expense forecast tends to be organized by what the money is being spent on such as office space, employee salaries, or computer hardware and software.
Building a set of projected financial statements is more complicated. For one, it requires keeping track of not only what the company is going to be buying, but also where the purchased goods/services are used. In the straightforward example of a widget manufacturer, expenditures on electricity (the “what”) can get spread across multiple line items on the Income Statement. Part of the spend may be assigned to Cost of Goods Sold, part to Marketing, and part to General & Administrative, all of which can be separate line items on the Income Statement (the “where”).
Creating a set of projected financial statements also requires understanding different types of expenses. Specifically, is an expense an operating expense (generally speaking, spend on a good or service that is consumed immediately) or a capital expense (spend on an asset that will be used up more gradually over time)? The former will impact the Income Statement, Balance Sheet, and Cash Flow Statement while the latter will only impact the Balance Sheet and Cash Flow Statement (although as the asset depreciates, the depreciation will show up on the Income Statement).
To keep track of all of this, companies assign every expense to a Cost Center (tells where the spending occurs, indicating the line item on the Income Statement that will be impacted), a Cost Code (which indicates what was purchased, e.g. Office Supplies, Salaries, Utilities, etc.) and a spend type (e.g. Capital vs. Operating).
Finally, building projected financials requires a strong understanding of the interactions between the three financial statements.
Due to the added complexity of building projected financial statements and because Dick and Jane are currently focused on cash, Dick chose to build a cash forecast. This is fine for now, but eventually SayAhh will need to become sophisticated enough to build projected financial statements.
2. Choosing the right drivers for each expense category
Just as it was important for Jane to choose the right drivers for her revenue projections, it is similarly important for Dick to choose the right drivers for his expense forecast. Since this was addressed on the revenue side, we won’t go into details on the expense side.
3. Accounting for unforeseen expenses
Dick is confident that his forecast will capture SayAhh’s major business expenses. But how should he forecast unanticipated expenses? Dick decided that unanticipated expenses will be equal to 10% of anticipated expenses in order to provide a cushion in SayAhh’s budget.
4. Putting it all together
With that, SayAhh now has their initial set of revenue & expense projections. Subtracting the expenses from the revenues provides a forecast of cash flow from operations. Dick and Jane are not currently anticipating any additional cash flow from financing (or investments), so these projections are a good indication of SayAhh’s anticipated cash burn, which will help Dick and Jane determine when/if they need to raise more money.
Last night I gave a talk hosted by SVB at their Palo Alto office. It was part of the “Never Ending All Old Is New Again Venture Deals Book Tour.” I had a ton of fun talking to and answering questions from about 75 entrepreneurs who – at the minimum – enjoyed eating the great food and wine that SVB provided on a luscious evening in Palo Alto. Oh – and I signed a bunch of copies of Venture Deals.
Several questions came up about Convertible Debt. We touch on it in Venture Deals but realized that we didn’t cover it in enough depth so Jason recently wrote a Convertible Debt series on Ask the VC. The series is now complete – here are the links to the posts in order.
- Convertible Debt Series
- Convertible Debt – The Discount
- Convertible Debt – Valuation Caps
- Convertible Debt – Conversion Mechanics
- Convertible Debt – Conversion In A Sale Of The Company
- Convertible Debt – Other Terms
- Convertible Debt – Warrants
- Convertible Debt – Early Versus Late Stage Dynamics
- Convertible Debt – Wrap Up
If you feel like we missed anything, or got anything wrong, or were confusing in our explanation, please chime in on the comments on the post. If you want to see an actual convertible debt term sheet or the actual legal documents, take a look at the TechStars Open Sourced Model Seed Financing Documents.
As a bonus to the evening, I got some direct, constructive feedback from one of the attendees via email later that night. While the “thank you” and “good job” notes are nice, I only learn when someone criticizes me (hopefully constructively, but I can handle it in any form.) The feedback was:
May I make a constructive criticism regarding your talk tonight? Your answers to audience questions tend to be overly long and rambling…..you “overanswer,” to invent a word. You start strong and respond right to the essence, but then your focus blurs and you keep taking verbal baby steps away from the thought stream. If you trim a minute or two off each answer, you can call on more people and hear more questions, which sends more people home happy. I think if you self-critique a video of yourself in a Q&A session, you’ll arrive at the same conclusion.
It’s a good suggestion. I often try to provide additional context to the question, but it sounds like – at least for one person – I went off on a few space jams that weren’t additive. I love the phrase “overanswer” – it’s a lesson from TV interviews 101 (e.g. just answer a question – any question – quickly). Something to ponder as I continue the Never Ending All Old Is New Again Venture Deals Book Tour.
Since last checking in with the SayAhh team, they have spent a few months consumed with building an early version of the product and speaking to potential customers, all the while watching their cash balance steadily diminish. They realize the clock is ticking and have decided that it is time to create a robust set of financial projections in order to provide themselves with a better sense of when they will need to raise more money.
The co-founders decided to divide-and-conquer, with Dick tackling expense projections and Jane tackling revenue projections. Their plan was to combine the two in order to predict their cash burn over the next two years (with a focus on the next twelve months). Jane asked Josh, who provided SayAhh with solid advice on setting up their accounting systems, for help in creating the revenue side of their financial forecast. Josh told Jane to take a first shot and he would comment. Here’s a snapshot of what Jane produced:
Josh worded his feedback carefully:
“Jane, this is a good start. I am glad to see that you are forecasting revenues based on business drivers. In this case, the # of users and the average monthly revenue per user. That’s what you should be doing. However, do you really understand the key underlying drivers of your business? Based on the drivers you chose, I am not so sure you do.
Certainly the # of users matters. But take it a step further. What drives the # of users? Presumably you will have new users, return users, and lost users each month. Decomposing users into these three component parts is important because it will allow you to better understand what is going on with your business, which will in turn allow you develop actionable strategies for improving your business.
For example, assume the # users remains flat for four months in a row. If you only track monthly users, you might assume that you are not attracting any new users and you need to change your marketing approach. However, what if it turns out that your marketing approach is just fine and you are bringing in lots of new users every month, but at the same time you are losing an equal number of existing users? In that case, the problem is that users don’t like your product. You need to fix that problem, not adjust your marketing approach. Take another shot at this and come back to me with a model that you think drills down to the key drivers of your business.”
Jane did some research, had a nice glass of wine, and really thought through their business model. Then she came back to Josh with a revenue model built on a set of key business drivers:
Josh told Jane that her second effort was much better and Jane in turn felt that she now had a much better understanding of SayAhh’s business model. A skeptic might assert that it is a waste of time for a pre-customer startup to forecast revenues since they are guaranteed to be incorrect. When I look at a startup’s revenue projections, I don’t pay much attention to the actual numbers for just that reason. However, I do look at the structure of the model to see if they really understand their business and are actively tracking their key business drivers.
In the next post, we will see how Dick fares with the expense forecast.
Note that Jane’s second attempt is a step in the right direction, but by no means perfect. Tying the number of new users to advertising spend seems particularly questionable, for example. What other problems do you see? What has been your experience/advice in developing revenue projections?
Recently, several entrepreneurs and investors have asserted to me that they don’t think the terms on a convertible debt deal matter much. I was perplexed by the statement and asked each of them to tell me more. In every case, the person hadn’t really thought through the issues. Rather, they were just spouting what they believed was conventional wisdom about terms for seed deals.
In one of the entrepreneur cases, I explained how it was likely that they were going to be on the wrong side of the valuation discussion in the next financing based on one of the terms. In one of the investor cases, I explained the difference between a 2x return and a 15x return – using a real example – based on the way the note was written. And in a third case a separate potential angel investor in the deal brought up a specific term that was important to him that addressed a real concern.
We rarely do convertible debt at Foundry Group – we much prefer to do equity rounds, even at the seed stage. However, many of the seed rounds done in TechStars are done using convertible debt as are many financings of less than $1m. So, if you are an entrepreneur or seed investor, I think it’s important to understand how convertible debt works and what the impact of various terms are.
In Venture Deals: Be Smarter Than Your Lawyer and Venture Capitalist, my partner Jason Mendelson and I touched on convertible debt but didn’t go into much detail on the specific terms. A number of people have asked us about them since the book came out so we’ve started a Convertible Debt series on AsktheVC. The first three posts are up:
- Convertible Debt Series
- Convertible Debt – The Discount
- Convertible Debt – Valuation Caps
There are nine posts in the series – coming out every Tuesday and Thursday until we are done. If you notice anything confusing, or incorrect, please comment and/or ask questions so we can clarify and/or fix.
If you can’t wait for the full series, take a look at the annotated term sheet for a convertible note on the TechStars site (also available on the AsktheVC Resources page.)
Now that Dick and Jane have added a CTO to SayAhh’s founding team, they’ve turned their full attention to working on their product. Today, we’ll look at the impact of the expenses to date on the P&L, Balance Sheet, and Cash Flow Statement.
Since SayAhh is in the pre-launch development stage, the company doesn’t have any revenue yet. They also haven’t launched a product, so there is no corresponding “cost of goods sold” – the direct cost of delivering their product. This results in a gross margin of $0, where gross margin is revenue – cost of goods sold.
The default Quickbooks setup uses “Income” to refer to “Revenue”. Since the Income (“Revenue”) line is $0 and the the gross margin is $0, Dick and Jane haven’t really noticed this yet. For now, we’ll leave it as is but once Dick and Jane meet with a mentor who is a CFO we expect this will change.
As of Aug 31st, here is their P&L.
The largest expense a company usually has at this stage is salaries. However, Dick, Jane and Praveena have decided to initially forgo salaries which helps them conserve cash in the near term. A company at this stage could also face product development costs from consultants if they decided to outsource product development. However, Praveena has committed to personally get the first version of the product up and launched without outside consultants, so there is no expense here either.
Dick is focusing his effort on getting some early customer validation and is using a Lean Startup approach. Dick’s friend Samir, who is hoping to land a job with Sayahh, agreed to put together several static landing pages and email collection forms. Once these were up Dick launched several AdWords campaigns to test customer interest.
Dick, Jane, and Praveena decided to get a small office so they could work out of the same space. Dick recently had a child and didn’t want to use his house as it was too distracting, and both Jane and Praveena felt like their apartments were too small to all cram into. They made the decision that being together every day was better than working separately, so they signed a 1-year lease at $1500/month (prorated from mid-August) and they invested $1930 in capital improvements to remodel the entryway and install a sign. After signing the lease, Samir suggested that they could have saved a lot of money by using a co-working space but once the decision was made and the lease signed, there was no turning back.
In addition to the capital improvements (which show up on the balance sheet below as “Leasehold Improvements”) our fearless founders bought some tables, chairs, and a few other random things at Office Depot. Both the renovations and furniture purchases are “capitalized” on their balance sheet rather than being expenses on the P&L. While the cash is gone, the “expense” is “depreciated” over several years (depending on the type of asset).
Following is the balance sheet and the changes from July to August.
Our founders had some other expenses, including business cards and a trip to an industry conference where they talked to a number of potential customers. While the conference was educational, Dick and Jane were frustrated with the dull gaze they got from uninterested prospects when they tried to explain what they were doing, but couldn’t actually show anything. On the flight home from the conference, Dick and Jane agreed they both needed to help Praveena get the first product out, whatever it took.
Following is the third key financial statement – the Statement of Cash Flows.
In total, SayAhh burned through over $8000 during the month. Annualizing this number, SayAhh could expect around $96,000 in negative cash flow for the year. However, Jane realized that $3430 associated with the new office space security deposit and rennovations is essentially a one-time expense. This resulted in an annualized burn rate more in the neighborhood of $55,200 ($4,600 * 12).
As Finance Fridays continues, we are introducing the concept of the Cap Table. We recognize that we are still at the very early basics stage, but as we are taking a case study approach to this we feel like we have to set up all of the pieces before we get into the messy guts. Hopefully you are staying with us and finding this useful – feedback welcome!
Jane and Dick, our fearless cofounders of SayAhh, have set up an accounting system and created their first set of financial statements. This week they set out to create their cap table and hire a CTO.
The founders each have common shares that will vest over four years. The vesting schedule protects each of the co-founders in case one gets hit by a bus or decides to drop the project after a short period of time. Also, there is an important tax election called an 83(b) election that they made which allows them to recognize and pay taxes for very small income of the value of the shares. Later, if they sell, the low tax basis and capital gains tax rates result in a lower tax liability than if they didn’t file the 83(b) election.
Equity is split 55% and 45%, but where is that officially recorded? It is not in the three primary financial statements (the Balance Sheet, Profit & Loss, and Cash Flow Statement.) Rather, it gets recorded in a document called the Capitalization Table (or “Cap Table”), which shows the ownership stake each person or entity has in the business.
Below you can see Jane and Dick own 55% and 45%, respectively. As first time entrepreneurs they did not create an employee options pool; we’ll fix that in a little while.
Jane and Dick want to bring in their friend Praveena as CTO, but they don’t know how to structure the compensation. They come up with two options:
- Hire Praveena as an employee and offer her stock options.
- Bring Praveena in as a founder and offer 10-20% of the company as stock.
The benefit of hiring Praveena is they think they could keep more equity and control of the company. But, Praveena hails from the land of big paychecks and is not ready to leave that without considerable equity. With the funds Jane and Dick have, a big salary is not possible. Praveena wants to invest $20,000 and get 20% equity.
After several discussions (and more beer), Jane and Dick agreed with Praveena to bring her on as a cofounder where she invests $20,000 and also gets 15% equity. Praveena is just like the other two founders, where her equity will vest over 4 years. Time to update the cap table.
When you read the cap table, think of it as a series of events that add new columns to the right. Now there are two events: the initial issuance of founders common shares, and then issuing new founders common shares along with creating an options pool. In this manner, you can see both the current equity distribution of the company, as well as historically what the equity holdings looked like.
If the full pool were to be given out, the dilution is fairly significant to the founders. They would own from 55% and 45% down to 36% and 29%, but until options are exercised they are not diluted. Jane and Dick contemplated a small option pool because they had read about the risk of an option pool shuffle, but ultimately decided to make it 20% based on feedback from their friend Josh, a Boston-based venture capitalist.
Our (now three) co-founders begin building out their product. The co-founders have savings to live off of and cash will be conserved by not having any salaries. Next week we will fast forward to when they have a beta product and they build a model to pitch to investors.