Category: Venture Capital
I got the following question from a friend yesterday.
“I’ve had a few conversations recently about how individual seed investors are getting kind of tapped out – for a variety of reasons, but in general it’s not that easy to find people who are still actively investing. I don’t recall your having blogged about this – are you seeing it too? Lots of talk about Series A crunch but maybe there is a seed crunch too?”
I blasted out a response by email, which follows. If you are an active angel, I’d love to hear what you think.
I’m not seeing much evidence of this – yet …
I have seen some of the more prolific angels start to slow down because capital is not recycling as fast as they are putting it out. That’s a pretty common phenomenon. But generally the pool of angel investors is increasing and the prolific ones who have a strategy (such as the angel strategy I advocate) seem to be keeping a steady pace.
There is also a huge amount of seed capital available from seed funds. Some angels are no longer competitive as they are overly price focused (e.g. if the valuation goes above $3m pre it’s too late for me). And the convertible note phenomenon hasn’t helped as many seed deals just keep raising small amounts of convertible debt.
The supply / demand imbalance is way off. While there is an increasing amount of seed capital / seed investors, the number of companies seeking seed investment has grown much faster in the last 24 months.
Also, I think some angels are just tired of the deal velocity. You have to work at it now more to stay in the flow because there’s just so much more of it, and that makes angels, especially semi-retired ones, tired.
If there is a big public market correction and angels feels (a) less wealthy and (b) less liquid (or not liquid), you’ll see a major pullback.
I feel like we are in a sloppy part of the cycle. Everyone is suddenly nervous. There are lots of uncomfortable macro signs, but it’s hard to get a feel for where things are really heading. And, at the same time, the cycle of innovation is intense – there is a huge amount of interesting stuff being created at all levels. And there is a massive amount of capital available that is seeking real returns, vs. low single digits.
The current usage of the word unicorn makes me tired. I could rant about it for a while, but that would make me tired of myself ranting about it.
Instead, I’d like to focus on a word that appeared a month ago by Aileen Lee in Welcome To The Unicorn Club, 2015: Learning From Billion-Dollar Companies. That word is unicorpse.
From section #6 in Aileen’s post:
“Given how much capital our private companies have raised in the past few years, most likely have cash to fund 2-4+ more years of runway. If private capital is no longer available in the future, these companies will seek a public offering or acquisition. Some will demonstrate strategically justifiable metrics and have fantastic ‘up round’ exits; others may see liquidation preferences kick in which will negatively impact founders and employees; others may fulfill the adage “IPO is the new down round”, which has been the case for more than half of the public companies on our list. Or worse, some may become “Unicorpses” :)).”
The word showed up again in Nick Bilton’s Vanity Fair article Is Silicon Valley in Another Bubble . . . and What Could Burst It?
“Indeed, contrary to Kupor’s argument at the Rosewood, it is this later-stage investing—with its shortage of regulation, tremendous envy, and Schadenfreude—that worries many bubble-watchers. “We basically doubled the number of unicorns in the past year and a half,” says Aileen Lee, the founder of Cowboy Ventures, who has herself become a mythic creature in the Valley after coining the term. “But a lot of these are paper unicorns, so their valuations may not be real for a while.” Others, Lee acknowledged, may never see their balance sheets add enough zeros to justify the title. They will be given a new sobriquet: “unicorpse.””
Yesterday, Erin Griffith had a perfect chance to use unicorpse in her article VCs have ‘Dying Unicorn’ lists, but they aren’t sharing them but she missed the layup and went with dying unicorn instead.
“But amid all the unicorns getting their horns, investors have warned of “dead unicorns.” In March, investor Bill Gurley made headlines with his pronouncement that “a complete absence of fear” would lead to dead unicorns this year. Venture capitalist Marc Andreessen warned in a tweetstorm that startups with high burn rates would “vaporize.” Last week Salesforce CEO Marc Benioff also predicted dead unicorns as startups seem to focus more on their valuations than their customers.”
Now, I don’t blame Aileen for the word unicorn. And I credit her for unicorpse, which I expect will be a lot more prevalent in the future. It’s not, in Bilton’s language, schadenfreude on my part. Instead, I believe that by focusing on the concept of a unicorn, we are paying attention to exactly the wrong thing.
I once simultaneously sat on the boards of three public companies that were all worth more than $1 billion. One went bankrupt, one was acquired for $0.14 / share ($40m), and one was acquired for $0.025 / share ($25m). I think you can call two of them as unicorpses and one of them a unicorpse with nothing left but dust where the bones should have been.
Don’t feel bad for me. I once was on the board of a company that had generated lifetime revenue of $1.5m and was acquired by a public company for $280m of stock which, by the time the deal closed, was worth around $1.1 billion. Two years later, the public company (which at one point was worth over $30b) was bankrupt.
None of these companies were ultimately worth $1 billion or more. Each of them stumbled for different reasons, but a lack of obsessive focus on product and customer was a big part of why they vaporized. They assumed, regardless of how much capital they had, that they could raise more. They didn’t focus on building a long term, sustainable business that had a huge protective moat around it. I don’t care how disruptive you are – if you don’t build a moat, someone is going to come disrupt you.
I’m encountering an increasing number of companies with burn rates in the stratosphere. I get uncomfortable when the net burn rate for a company goes above $500k / month. In fast growing companies with a balance sheet > $25m I can stomach a $1m / month net burn. But when I see $2m / month net burn rates, I vomit. And a $4m / month net burn rate, even if you have $100m on your balance sheet, makes me physically ill.
As an investor, would I rather own 30% of a company that is acquired for $300m in cash that had only raised $10m or 2% of a company with a paper value of $1b and $200m of liquidation preferences? As a founder, would you rather own 10% of the company that sold for $300m in cash or 2% of a company with a paper value of $1b and $200m of liquidation preferences? There is a lot more in the calculation of value, especially who gets what, than that $1 billion unicorn thingy.
Let me say it a different way.
There is nothing special or magical about $1 billion valuation. It’s just a number.
I’m not predicting a bubble or anything else. I’m not negative about where we are at in the cycle. I hope to live another 50 years as I think this is going to be the most interesting point in the history of our species up to this point.
But I do think it’d be useful for more founders and investors to ponder unicorpses and spend less of their energy talking about, and trying to become, unicorns, lest you one day find yourself a pile of dusty bones.
I don’t listen to that many podcasts, but I like ones that are a short (< 45 minute) interview format. I can listen to one of these on a run or a drive to/from my office.
Until recently, the only one I was listening to regularly was the Reboot.io podcast. Jerry Colonna, the co-founder of Reboot.io is a dear friend and his interviews are often magical.
A few months ago I noticed The Twenty Minute VC by Harry Stebbings. I can’t remember which one was the first one I listened to, but I thought his style and interview approach was great. It was fast, started with an origin story, but quickly moved on to the present and then ended with a set of short questions.
Jon Staenberg, a long-time friend from Seattle who did an interview with Harry on episode 034, dropped me the following email at the end of April:
He seems like a good guy, want to be part of his podcast?
U good?
Ever in seattle?
I told Jon I’d be game. Harry responded immediately and we did a podcast together six weeks ago. I’d been listening regularly since Jon introduced us and heard several great podcasts, including mentions of me in 055 with Jonathon Triest and 059 with Arteen Arabshahi.
Last week Harry releases two episodes 065 with me and 066 with my partner Seth Levine. I had fun doing mine but absolutely loved listening to the one with Seth, especially around his version of the Foundry Group origin story.
Harry promises to interview our other two partners – Ryan McIntyre and Jason Mendelson – so he’ll ultimately have a triangulation (or maybe a trilateration) of our origin story.
In the mean time, enjoy the interviews with me and with Seth if you are looking for a podcast to listen to.
In January, Jerry Neumann wrote a long and detailed analysis of his view of the VC industry in the 1980’s titled Heat Death: Venture Capital in the 1980’s. While I don’t know Jerry very well, I like him and thought his post was extremely detailed and thoughtful. However, there were some things in it that didn’t ring true for me.
I sent out a few emails to mentors of mine who had been VCs in the 1980s. As I waited for reactions, I saw Jerry’s post get widely read and passed around. Many people used it as justification for stuff and there were very few critical responses that dug deeper on the history.
Jack Tankersley, a long time mentor of mine, co-founder of Centennial Funds, and co-founder of Meritage Funds, wrote me a very long response. I decided to sit on it for a while and continue to ponder the history of VC in the 1980’s and the current era we are experiencing to see if anything new appeared after Jerry’s post.
There hasn’t been much so after some back and forth and editing with Jack, following is his reaction to Jerry’s piece along with some additional thoughts to chew on.
It is good that Mr. Neumann begins his piece in the 70’s, as that era certainly set the table for the 1980’s. You may recall I got into the industry in 1978.
The key reason for the explosion in capital flowing into the industry, and therefore the large increase in practitioners, had nothing to do with 1970’s performance, early stage investing, or technology. Instead, it was the result of two profound regulatory changes, the 1978 Steiger Amendment, which lowered the capital gains tax from 49% to 28%, and the 1978 clarification under ERISA that venture capital investments came within the “prudent man” doctrine. Without these changes, the 1980’s from a venture perspective would not have happened and the industry would have remained a backwater until comparable regulation changes stimulating capital formation were made.
Secondly, the driver of returns for the funds raised in 1978 – 1981 was not their underlying portfolios, at what stage, or in what industries they were built. Instead, the driver was the 1983 bull market. The Four Horsemen (LF Rothschild, Unterberg Tobin, Alex Brown, H&Q and Robinson Stephens) basically were able to take any and everything public. Put a willing and forgiving exit market following any investment period and you get spectacular returns.
So contrary to the piece, it wasn’t VC were good at early stage technology, it was that they had newfound capital and a big exit window. For example, my firm at the time, Continental Illinois Venture Corporation, the wholly owned SBIC of Chicago’s Continental Bank, had many successful investments. Some were Silicon Valley early stage companies, such as Apple, Quantum, and Masstor Systems. I handled CIVC’s investments in the latter two (in fact, I also “monitored” Apple as well). Take a look at the founding syndicates of each:
| Masstor Sytems (5/1979) | Quantum Corporation (6/1980) | ||
| CIVC | $ 250,000 | CIVC | $ 200,000 |
| Mayfield II | $ 250,000 | Sutter Hill | $ 790,000 |
| Continental Capital* | $ 250,000 | KPC&B II | $ 775,000 |
| Genstar** | $ 275,000 | SBE+ | $ 700,000 |
| S & S*** | $ 225,000 | Mayfield III | $ 500,000 |
| BJ Cassin | $ 75,000 | ||
| Total | $1,250,000 | Total | $3,040,000 |
*Highly regarded private SBIC, **Sutter Hill Affiliate, ***Norwegian Shipping Family, +B of A’s SBIC
What is striking about these syndicates is that nobody had any meaningful capital, which forced syndication and cooperation. CIVC’s only “competitive” advantage was its ability to write a check up to $1 million. In this era, the leading VC firms such as Mayfield, Kleiner, and Sutter Hill (all shown above), rarely invested more than $1 million per company.
When we syndicated the purchase of the Buffalo, New York cable system, we literally called everybody we knew and raised an unprecedented $16 million, a breathtaking sum in 1980. As dollars flowed into the industry, cooperation was replaced by competition, to the detriment of deal flow, due diligence, ability to add value and, of course, returns.
CIVC had a number of highly successful non-technology investments made in the late 1970’s timeframe, such as:
- LB Foster: Repurposed old train tracks
- JD Robinson Jewelers: The original “diamond man” (Tom Shane’s inspiration)
- National Demographics: Mailing Lists
- American Home Video: Video Stores
- Michigan Cottage Cheese: Yoplait Yogurt
- The Aviation Group: Expedited small package delivery
- JMB Realty: Real Estate Management company
None of these companies fit Mr. Neumann’s definition of the era’s venture deals and each generated returns we would welcome today.
For many years preceding 1999, the 1982 vintage was known as the industry’s worst vintage year. Was this a function of “too much money chasing too few deals” as many pundits claimed? Not really; it was a result of an industry investing into a frothy market at higher and higher valuations in expectation of near term liquidity, and suddenly the IPO window shutting, leading to no exits and little additional capital to support these companies.
Mr. Neumann’s post also misses the idea that it was a period of experimentation for the industry, This time period saw the rise of the industry-focused funds and the advent of the regional funds. Many of the industry funds were wildly successful (in sectors such as media communications, health care, consumer, etc.), while none of the non-Silicon Valley regional firms were long-term successful as regional firms. Some regional firms, such as Austin Ventures (in Austin, TX) did prosper because they subsequently adopted either an industry or national focus. The remainder failed as a result of the phenomenon of investing in the best deals in their region which typically were not competitive on a national or global scale. Just imagine doing Colorado’s best medical device deal which was only the 12th best in its sector in the world.
Some additional observations include:
- Many of those quoted in the article such as Charlie Lea, Kevin Landry, Ken Rind, and Fred Adler, were all very well known in the industry. However, none were based in the Silicon Valley and are probably unfamiliar names to today’s practitioners. I knew them all, because we all knew each other in this era.
- “By January 1984, investors had turned away from hardware toward software.” This isn’t true. Exabyte, one of Colorado’s hottest deals, was formed in 1985; Connor Peripherals (fastest growing company in the history of technology manufacturing, four years to $1 billion in revenue) raised its first round in 1987.
- “By 1994 the big software wins of the 1980’s were already funded or public.” This isn’t correct either. A good example is Symantec
- “Ben Rosen, arguably the best VC of the era”. While Ben may well have been among the best, in the early 1980’s Ben was brand new to the industry. He was a former Wall Street analyst with no operating or investment experience, who became a VC by teaming up with operator LJ Sevin. Even many newcomers with little real experience were quite successful.
- Silicon Valley firms also did many non-tech deals. Sequoia followed Nolen Bushnell from Atari into Pizza Time Theaters (and according to legend, did well). I well remember being in Don Valentine’s office as he waxed poetically about his new deal, Malibu Race Track. Unfortunately Reed Dennis of IVP did not do as well in his Fargo, ND-based Steiger Tractor investment!
- “Venture capitalists’ job is to invest in risky projects.” This statement is scary to me. We should be risk evaluators, not risk takers. We should invest where our background and instincts and due diligence convince us the anticipated return will far exceed our evaluation of the risk. There are five key risks in any deal: Market, Product (a/k/a technology), Management, Business Model, and Capital. Taking all five at once is crazy. Most losses happen when you combine Market and Product risk – take one, not both, and take it with a proven entrepreneur.
- “The fatal flaw of the 80’s was fear”. I strongly disagree. Instead, it was the result of virtually no liquidity windows after 1983. As mentioned, the industry also experimented with new strategies such as industry focus funds and regional focus funds. Some worked; some did not. Also in the 80’s, the megafunds were created (at the time defined as $100 million plus); the LBO sector outperformed venture through financial engineering; asset gatherers, such as Blackstone, were created. The biggest Wall Street crash since the Great Depression (October, 1987) shocked us all. “They don’t talk about the 80’s”; if true, maybe it’s because the period cannot be simplified.
The 1980’s proved there is more than one way to “skin a cat”. Early stage technology may be one; but it is not the only one and may not be the best one, then or now. My advice to a venture capitalist, then, now or later, is simple: Do what you know, do what you love; build great companies and over time you will succeed.
On my run this morning (yay – I’m running again) I listened to a wonderful podcast between Jerry Colonna and Bijan Sabet called Investors are Human Too – with Bijan Sabet.
If you follow me, you know that I’m incredibly close friends with Jerry (he’s one of the people on this planet that I comfortably say that I love). I’m also a huge fan of his company Reboot.io. If you want a taste of what they do, listen to a bunch of the Reboot podcasts (I’ve listened to them all and the least interesting one is still excellent.)
I’m also a big fan of Bijan. We’ve had a number of great conversations over the years. While we haven’t sat on a board together, I have deep respect for how he functions as a VC – and as a human.
At Foundry Group, we’ve done a number of investments with Bijan’s firm Spark Capital, including AdMeld (sold – very successful investment), Trigget (sold, but not a successful investment), and most recently Sourcepoint. We’ve also got another one in the works together that should close by the end of August.
Unlike so many podcasts with VCs where you get lots of personal history followed by advice, prognostications, bloviating, and predications, this one was all about being human. Bijan and Jerry explored things in the context of the relationship between a founder and a VC. They covered things generally, had some great examples (including Jerry and Mainspring, which was a blast from the past for me), and then Bijan went deep on his own journey to figure this out over the past ten years.
My favorite line came near then end when Bijan talked about encountering VCs who hide behind the phrase “fiduciary responsibility” to justify their actions, when in fact they should just say:
“I have a fiduciary responsibility to treat you like shit.”
Even though I was huffing and puffing on my run, I laughed out loud.
If you are a podcast listener, spend 45 minutes of your life on this. It’s worth it. Bijan and Jerry – thanks for the conversation and for brightening up my run.
This is not a post about a bubble, real or imagined. It’s a lesson from when I was 20 years old.
I showed up at MIT as an eager freshman. I was 17, from Dallas, with a nice pair of cowboy boots and long hair. On my first day, at the freshman picnic, I heard that 50% of us would end up in the bottom half of our class. Fifteen minutes later I was whisked away in a white van to ADP, the fraternity I ended up pledging and living in for four years, next to WILG and across the street from The Mandarin (no longer there), Mary Chung (still there and still awesome), and Toscanini’s (still there and even more awesome.) That night I met Dave Jilk, my first business partner and one of my best friends.
Dave was a senior and I was a freshman. He took me under his wing and we became thick as thieves. He was Course 6 and easily one of the best coders around, even though we didn’t call them coders there. I was pretty good also, but limited to BASIC and Pascal, which were the two languages I used to write the commercial software I was working on for Petcom. Dave was into business, read Forbes cover to cover each time it came out, and hung around with some Sloan people. We’d go to Mandarin, Mary Chung, or somewhere in the North End, eat and drink way too much, and talk about computers and business. Ok – we talked about other things that 18 – 22 year old young men talk about, but there was a lot of computers and business in the mix.
Petcom, the company I worked for, wrote PC-based oil and gas software. They had one competitor – David P. Cook and Associates (which, in a twist of irony, morphed into Blockbuster – if you don’t know the story, Wikipedia has a fun history snippet.) In addition to getting paid $10 / hour (which quickly taught me that if I worked more hours, I got paid more money) I received a 5% royalty on gross sales of the two products I wrote (PC Log and PC Economics).
In 1983 the oil business was booming and Petcom was growing quickly. As a freshman, I’d get a monthly royalty check – sometimes $1,000, sometimes $2,500, and once $11,000. I never knew what it was going to be, so I was always very excited when the blue Petcom check showed up at 351 Massachusetts Avenue in my mail cubby. I’d often grab a bunch of frat brothers for lunch, go to Mandarin, and pay for whatever we ate.
via chartsbin.com
The graph gives away the punch line.
While the price of oil more than doubled between 1978 and 1979, from $14 to $31 / barrel, it had been slowly drifting down from a high of almost $37 in 1980 to $29 in 1983. But that drift was seductive since it was so much higher than the $14 / barrel in 1978 and created this sense that it would once again go much higher.
In the summer of 1985, I was working full time at Petcom. Things for the company were absolutely rocking. We had grown from three people (the two founder + me) when I started to over 20 people. We had fancy offices on the 7th floor of a building across the street in the Dallas from the beautiful Galleria Mall. Software was being sold, my royalty checks were huge (I think I made around $80,000 in 1985, but that’s just a vague guess), and life was grand.
I went back to school in the fall. That’s when I uttered a deeply stupid phrase to Dave.
“Oil Prices Will Go Up Forever”
Dave challenged me. We argued. We probably went out to dinner somewhere in the North End, ate a huge amount of pasta and red wine, and then went to The Parker House in downtown Boston and drank scotch until we eventually stumbled back to 351 Mass Ave.
In December, 1985, Saudi Arabia flooded the market for oil and by the end of 1986 the price of a barrel of oil was around $10.
I didn’t work at Petcom that summer. Their phones stopped ringing. Customers went out of business right and left. The company shrunk back down to the two founders who then started the first CD music store in Dallas, repurposing their software for the CD business, just like David P. Cook had done for the video business. My royalty checks had stopped, but fortunately I had started Feld Technologies and 1986 was the summer of 2430 Denmark in Garland, Texas.
The oil and gas business wasn’t the only one that got slaughtered by this. Texas real estate was booming, until it wasn’t. My dad, a doctor, was a small partner in a bunch of real estate partnerships. By 1990 he was a large partner in a small number of the real estate partnerships that hadn’t failed, as he was one of the few partners who could keep writing checks. I don’t know exactly how it turned out for him, but since he had staying power I expect he broke even or even made some money. But I remember the stress around the dinner table when I was home in the summer and over the phone when we talked as he was fighting through what was likely a very similar mess to the one I would encounter several times later in my life.
I learned a powerful lesson that laid some fundamental groundwork for how I think about business. In the Internet bubble, while I kept this lesson in the back of my mind, I ended up suspending disbelief, like so many others, in 2000 and into the spring of 2001. I learned this lesson again, but in a more profound way.
Through each of these aggressive down cycles, amazing companies were created. Some of the great real estate fortunes emerged from the rubble of Dallas in the 1980s. You don’t have to look very far to see some remarkable companies that survived and transcended the Internet bubble collapsing in 2001. And for many, 2008 and 2009 seems very far in the distant past, even though it still massively impacts others in a very negative way.
Oil prices do not go up forever. Neither does anything else.
Here’s the scenario. A company raises $2m of seed money from angels in a convertible note with a $6m cap. Assuming equity is raised at or above that cap, the total dilution, before the new money, is 33% (equivalent to an equity financing of $2m at a $6m post money valuation.
The company spends the $2m building and launching their first product. The first release is underwhelming, but they iterate aggressively, with feedback and support from some of their angel investors. The product gets a lot better. They go out to raise a Series A, but there are no takers. The feedback is “come back when you’ve made more progress with customers.” They are running out of money.
One of their angel investors, who happens to be a VC firm, decides to invest another $500,000 in the company. But instead of adding it on to the note or doing an equity round with a price, which could still be an early stage price but below the cap, they make the argument that since the company couldn’t raise a round, the company is worthless.
So they recapitalize the company. The term sheet converts all the convertible debt into a post-money valuation of $100k, essentially making the convertible debt worthless. The new money comes in at a pre-money valuation of $100k, but includes a complete refresh of founder equity to 40% of the company. So the new investment gets 60%, the founders get 39.9%, and the $2m of seed money gets 0.1%.
As part of this, all of the seed investors get a chance to participate in the round prorata to preserve their ownership percentage. But this equity round is going to be controlled completely by the VC who just did the recap.
Yup – this just happened to us in an FG Angels deal. It blew my mind. We signed the paperwork, wrote our investment off, and walked away. We have no interest in re-investing alongside a VC firm that doesn’t respect a $2m investment by seed / angel investors. While we understand the pressure the founder was likely under, we don’t accept the notion of the bribe where the founders get 39.9% and the investors, who put up $2m in a convertible note, get 0.1%.
Sure – it happens. It usually happens in a later round, when the company is in fact worth much less than the liquidation preference overhang and insiders use a pay-to-play and a low valuation to reset the preferences and the cap table. The founders usually get wiped out completely, but existing management usually ends up with new options for between 10% and 20% of the company. It’s not pretty, but it happens.
But in this cycle, I hadn’t seen it in a seed round.
When I made 40 seed investments between 1994 and 1996, I had a philosophy that I’d double down on a seed investment. If I put $25k into a company, it made progress, but couldn’t get to the next level where it could raise a round, I’d offer up another $25k at the same price. If I was leading a gang of friends (that’s what I called it before the word syndicate started to be used), and that gang had put in $200k alongside my $25k, I’d encourage my gang to do the same, and they often did. In some cases this turned into nothing, but in a few cases it had magnificent outcomes for me and my gang, along with the entrepreneurs. And, everyone, in either case, felt good about how things played out.
We are big boys and are fine walking away from investments that aren’t working. But it galls us when we make bad people decisions, which happens sometimes, but not that often anymore. In this case, we misread the respect – or lack thereof – that a co-investor and an entrepreneur would have for the other seed investors and the seed capital that helped them get a product built and into customer hands.
While I wish them well as a company, the individuals are no longer part of our gang. And the VC is a firm we have no interest in ever working with again. The entrepreneur and the VC may not care at all, and that’s fine with us, but we’ll remember the behavior for a long time.
In a single turn game, this might be rational behavior. But in a multi-turn game that lasts for a very long time, across multiple contexts, this is a bad strategy. And developing a reputation for recapping seed rounds is, in my book, silly.
I hope you had a nice 4th of July yesterday. Amy and I hid out all day in Longmont, playing with the dogs, napping, and reading. As a result yesterday was a three book day.
One of them was Semi-Organic Growth: Tactics and Strategies Behind Google’s Success by George T. Geis. If you are a Google watcher, aspire to have you company acquired by Google some day, or just want to understand Google’s approach to acquisitions (which Geis calls “semi-organic growth”) this is a must read book that is well worth the money.
Geis covers a detailed history of Google’s acquisitions along with a framework for how to think about them. It’s comprehensive and well done. We were investors in several of the companies mentioned and Geis gets the details, and the general context, correct. While I knew most of the history from just paying attention over the years, I learned a few things.
There was one construct that bothered me – Geis’ use of the phrase “acqui-hire” and his effort to categorize acquisitions as acquihires, ACQUI-hires, acqui-HIRES, and ACQUI-HIRES. His goal was to use “acquihire” as a substitute for acquisition, while emphasizing the relative importance of the product/technology or people in decision to make an acquisition.
I don’t like the use of the dash in the phrase, so I stubbornly don’t use it, just like I don’t like the dash in the word startup. I also don’t really like the word, as it has morphed to mean too many different things. I regularly hear people talk about any type of acquisition as an acquihire, rendering the nuance of the word meaningless.
While I appreciate Geis trying to use it as a framework for categorizing each acquisition, I wish he’d just come up with something simpler, like a set of things Google was searching for when they made an acquisition. The four that are most relevant in my mind are product, technology, customers, and people.
Acquihire only really refers to one of these things, which is people. The earliest use of the phrase I could find was in 2005 in Rex Hammock’s post Google acquires(?) Dodgeball.com.
Google acquires(?) Dodgeball.com: But really…When a public company with a market cap of $64.1 billion “acquires” a two-person company, isn’t that more like a “hire” with a signing bonus?
Hammock called it an “Acq-hire” and defined it as:
Acqhire – When a large company “purchases” a small company with no employees other than its founders, typically to obtain some special talent or a cool concept. (See, also: NFL first round draft signing bonus; book publishing “advance” after publisher bidding-war.)
Acquihires quickly expanded to cover deals that were more than just the founders, but clearly only talent acquisitions. In acquihires, the products were quickly abandoned as the team that was acquired went to work on the acquirers products. Often this was built on top of the concept that the acquiree brought to the table, but the core product was rarely used.
We went through a phase where acquihires were positive ways for large companies to pick up talented teams to work on a specific thing that was important to the acquirer. Then we went through a phase where acquihire often referred to the acquisition of a failing startup, just as a way to give the team a soft landing. Then acquires started using the concept of acquihire to try to shift consideration away from the cap table and instead increase the amount of “retention consideration” going to the remaining employees, independent of the capitalization of the company. If you take it to its logical conclusion, acquihire starts to be a substitute for acquisition.
I’m not a fan of this as I think it’s confusing. I like Hammond’s definition with the extension that it can include more than just the founders. But it’s clearly an acquisition of the people, not of the product, technology, and customers of the company being acquired.
I pains me as an investor when entrepreneurs talk about their goal of being acquihired by a large company. I think your goal should be to build something a lot more important and valuable than simply the team being acquired.
The other day, Mark Suster wrote a critically important post titled One Simple Paragraph Every Entrepreneur Should Add to Their Convertible Notes. Go read it – I’ll wait. Or, if you just want the paragraph, it’s:
“If this note converts at a price higher than the cap that you have been given you agree that in the conversion of the note into equity you agree to allow your stock to be converted such that you will receive no more than a 1x non-participating liquidation preference plus any agreed interest.”
I also have seen the problem Mark is describing. As an angel investor, I have never asked for a liquidation preference on conversion that is greater than the dollars I’ve invested. But, I’ve seen some angels ask for it (or even demand it), especially when there is ambiguity around this and the round happens much higher than the cap. The entity getting screwed on this term are the founders, who now have a greater liquidation preference hanging over their heads than the dollars invested by the angels. Mark has a superb example of how this works on his blog.
We’ve been regularly running into another problem with doing a financing after companies have raised convertible notes. Most notes are ambiguous as to whether they convert on a pre-money or a post-money basis. This can be especially confusing, and ambiguous, when there are multiple price caps. There are also some law firms whose standard documents are purposefully ambiguous to give the entrepreneur theoretical negotiating flexibility in the first priced round.
If the entrepreneur knows this and is using it proactively so they get a higher post-money valuation, that’s fair game. But if they don’t know this, and they are negotiating terms with a VC who is expecting the notes to convert in the pre-money, it can create a mess after the terms are agreed to somewhere between the term sheet stage and the final definitives. This mess is especially yucky if the lawyers don’t focus on the final cap table and the capitalization opinion until the last few days of the process. And, it gets even messier when some of the angels start suggesting that the ambiguity should work a certain way and the entrepreneur feels boxed in by the demands of his convertible note angels on one side and priced round VC on the other.
The simple solution is to define this clearly up front. For example, in the Mattermark investment from last year, I said “We are game to do $5m of $6.5m at $18.5m pre ($25m post).” When I made the offer, I did not know how the notes worked, what the cap was, or what the expectation of the angels were. But when Danielle Morrill and I agree on the terms, it was unambiguous that I expected the notes to convert in the pre-money.
In contrast, in the Glowforge deal, which Dan Shapiro talks about in his fun post Glowforge Completed its Series A with an Investor we Never Met, I was less crisp. I knew that Dan’s notes were uncapped with a discount and I knew his lawyer well, so I didn’t define the post-money in this case. Since the notes were uncapped, I expected them to convert into the pre-money. But I didn’t specify it. The notes were ambiguous and we focused on this at the end of the process after docs had gone out to the angel investors. Rather than fight about this, I accepted this as a miss on my part and let the post-money float up a little as a result. The total amount of the notes was relatively small so it didn’t have a huge impact on the economics of the investment but we could have avoided the ambiguity by dealing it with more clearly up front.
Recognize that this is simply a negotiation. In Mattermark’s case where there were a lot of notes stacked up, I cared a lot about the post-money. In Glowforge’s case where the note amount was modest, I didn’t care very much. And, while I care a lot about my entry point as an early stage investor, I’ve learned not to optimize for a small amount in the context of a pricing negotiation.
I think we are just starting to see the complexity, side effects, and unintended consequences created by the massive proliferation of convertible notes over the past few years. I’m pretty mellow about them as I’ve accepted that they are part of the funding landscape, in contrast to a number of angels and VCs who feel strongly one way or the other. As derivative note vehicles have appeared, such as SAFE, that try to create synthetic equity out of a note structure, we’ll see another wave of unintended consequences in the next few years. As someone who failed fast at creating a standardized set of seed documents in 2010, I’ve accepted that dealing with the complexity and side affects of all of the different documents is just part of the process.
Fundamentally, it’s up to the entrepreneur to be informed about what is going on. I hope Mark’s blog post, and this one, are additive to the overall base of entrepreneurial knowledge. And, if Jason and I ever write a third edition of Venture Deals: Be Smarter Than Your Lawyer and Venture Capitalist our chapter on convertible notes might now be two chapters.