How to estimate market size March 16, 2011Posted by jeremyliew in startups, VC.
As an entrepreneur, your time is a very valuable asset. It takes as much time and effort to build a business whether you’re attacking a small market or a big one. But the rewards for success in a big market are much greater, so it makes sense to attack big markets.
For the same reason,VCs are often very focused on market size. But there is is a lot of confusion about how to estimate market size. While you might play in a big industry, it is the Total Addressable Market size (TAM) that is really important.
TAM is really a pretty simple concept – it is what your revenue would be if you had 100% market share in your business. This is often radically different from what an analyst report estimates as market size as their view of the “market” can be quite different from what your product can address. Here is an excellent analysis from VigLink of their TAM:
Viglink allows publishers to put commerce links into their content with a universal affiliate code, and then tracks sales that originate from those links and pays out the affiliate fee. As you can see above, they have done a really nice job of starting with an enormous “market size” ($600bn+ ecommerce market) and broken it down into what is addressable by them, the network payout piece of commissions coming from affiliate orginated ecommerce transactions, which is still a $1b+ opportunity.
I’d urge other entrepreneurs to conduct similarly realistic analysis when they present market size estimates.
One difference between VCs and Entrepreneurs April 20, 2009Posted by jeremyliew in decision making, Entrepreneur, VC.
Steve Blank had a great post last week about speed and tempo in startup decision making recently where he says:
… think of decisions of having two states: those that are reversible and those that are irreversible. An example of a reversible decision could be adding a product feature, a new algorithm in the code, targeting a specific set of customers, etc. If the decision was a bad call you can unwind it in a reasonable period of time. An irreversible decision is firing an employee, launching your product, a five-year lease for an expensive new building, etc. These are usually difficult or impossible to reverse.
My advice was to start a policy of making reversible decisions before anyone left his office or before a meeting ended. In a startup it doesn’t matter if you’re 100% right 100% of the time. What matters is having forward momentum and a tight fact-based feedback loop (i.e. Customer Development) to help you quickly recognize and reverse any incorrect decisions. That’s why startups are agile. By the time a big company gets the committee to organize the subcommittee to pick a meeting date, your startup could have made 20 decisions, reversed five of them and implemented the fifteen that worked.
I think this is great advice.
Entrepreneurs will find that almost all of their decisions are reversible. As a result, good operators get into the habit of making decisions quickly even with incomplete information. Entrepreneurs make 1000s of reversible decisions per year.
On the other hand, VCs will find that almost all of their decisions are irreversible. You can’t really “ask for your money back” once you’ve made an investment. This is one reason that fundraising can take so much time and effort for entrepreneurs. VCs want to know as much as they can before making a decision. VCs make one or two irreversible decisions per year.
That’s a big difference in decision making style
Almost as many down rounds as up rounds in December 2008 March 4, 2009Posted by jeremyliew in recession, VC, Venture Capital.
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Fenwick and West analyzed 128 venture financings completed in q4 2008 for companies headquartered in the bay area and found that there has been a significant increase in the proportion of down rounds, with this trend accelerating:
“During the fourth quarter, up rounds exceeded down rounds 54% to 33% with 13% flat, the lowest amount by which up rounds exceeded down rounds since the third quarter of 2004,” said Barry Kramer, partner in the firm and co-author of the survey.
“Perhaps more ominously,” he said, “down rounds increased each month through the quarter, and for December 2008, 45% of all financings were down rounds, compared to 48% up and 7% flat.”
Note that bolding – almost as many down rounds as up rounds in december! Additionally, they found that in q4:
43% of C rounds were down rounds
22% of D rounds were down rounds
It’s hard to tell how many data points go into these numbers, but the proportion of series C down rounds is especially notable. This may indicate that in the past couple of years a high proportion of B rounds were overpriced. A round pricing has historically been fairly consistent across the last 10 years, which may explain why there are fewer B down rounds.
It is worth reading Fenwick’s full survey as it gives good data on the frequency of many other important venture financing terms such as particpating preferred, full ratchet dilution, multiple liquidation preferences etc.
How bad is it for startups seeking financing? November 24, 2008Posted by jeremyliew in start-up, startup, startups, VC, Venture Capital.
It is difficult for startup companies to raise venture capital at the best of times. A venture capitalist might get emailed 5-10 pitches from startups each day. Over the course of a year that adds up to 2,500-5,000 pitches. Of those pitches, that venture capitalist might fund one or two companies. Not great odds for a startup. Granted, some of the other startups may raise funding from other venture capital firms, but even so, it’s a chancy proposition.
Recently, startups have been facing an even more difficult environment for raising capital. There are three factors that are contributing to this. Some of these factors will change in the short term, but others will likely continue to be a factor for a while. From longest to shortest then:
Angel financing has dried up. Often, when a company is too early to raise institutional venture capital it will raise money from angel investors – wealthy individuals. According to the Center for Venture Research, $26B was invested by angels in 2007, a marked increase compared to $15.7B in 2002. The precipitous drop in stock markets and housing markets since the beginning of the year has made many angel investors nervous about making new investments in risky and illiquid startups. Many angel investors will likely sit on the sidelines until we see a rise in stock markets and in consumer confidence. While the companies who raise angel financing would not likely have raised from venture capital firms anyway, a slowing down of angel financing will mean that less companies are ready for institutional venture capital in the next few years.
A slowing economy has reduced near term revenue growth expectations. We are in a recession. While for many startups, the micro factors (e.g. Did we hire our second sales person in Q1 or Q3? Was our VC able to introduce us to BigCo for a distribution deal?) trump the macro factors, startups still operate in the same economy as everyone else. With consumers and enterprises alike watching their spending closely, even the most promising startups are likely to see slower growth than they might have projected a year ago. Slower revenue growth usually translates into a longer period before the company gets to profitability, and hence more capital required. Strong companies will still get funded, but each financing may be a little larger than in the recent past to give the companies the additional runway to get to profitability. As a result, there may be a slight reduction in the overall number of financings (given that the pool of available capital is largely the same) and some marginal companies will not be able to raise capital. Since early stage venture capital firms by definition take a long term view, this impact is likely small, but will persist until investor expectations for consumer and enterprise spending improve. As we get additional data on the likely length and depth of this recession through 2009, this effect will likely disappear.
Venture Capitalists are focusing on their portfolio companies. The slowing economy affects not just companies raising finance, but also companies that have already been funded. VCs are currently fully engaged with their current portfolio, helping them to prepare for a tough 2009. Many entrepreneurs are first time CEOs, and some were not even in the workforce during the last recession. They are turning to their VC investors to help them think through what actions their companies need to take to adjust; cost reductions, changes in strategic direction, or otherwise. This takes time. Time spent by VCs with portfolio companies is time not spent looking at new potential investments. As a result, companies currently seeking financing may not get the same level of attention that they might have received a few months ago. The good news for startups is that this is a short term effect. 2009 planning should be completed within the next few weeks, and certainly after the holidays, venture capitalists time will once again free up to look at new deals.
Better time ahead. Although startups seeking financing right now may have a tough time, as these factors fade away they should see a relative improvement in the very short term. As the market will only improve, startups looking to raise new financing should try to defer for as long as possible. This may require cutting costs to extend the cash runway, reducing the scope of projects, prioritizing revenue over new features or looking to existing investors to provide a bridge loan. But do not lose hope! Promising companies will continue to get funded, with the pace returning to close to normal by part way through 2009.
An entrepreneur asked me recently if I was concerned about the impact the credit crunch will have on venture financing for startups. I responded:
For high quality companies, the short answer is no. The more nuanced answer is that
(i) The credit crunch will impact venture debt (already has) so people can’t count on that to extend their runway, so should raise a bit more than they would have done
(ii) If the economy indeed slips into recession (as a second order effect of the credit crunch), then this will impact sales growth for many startups, whether selling to enterprises or consumers. This will also impact timelines to profitability, and hence amount raised. It will also likely cause some angels and some venture firms (especially corporate venture firms and firms with a shorter time horizon) to become less active investors.
At Lightspeed as we take a long term view towards the companies we invest in. However, we are urging them to be conservative in their revenue projections and hence cash planning (both from amount raised and from cash burn perspective).
GigaOm weighs in on the venture debt issue in particular
Fewer, costlier loans. No way around it, money is getting more expensive. As long as banks are licking their wounded balance sheets, they won’t make loans that carry even a whiff of risk. This could raise borrowing costs and complicate growth for capital-intensive sectors, like telecom.
A more immediate problems lurks in short-term lending such as commercial paper. Interest rates in that part of the market have recently risen from 2 percent to 4.5 percent for riskier companies, according to Businessweek.
Fred Wilson has a similar perspective on the venture capital market:
All startups are going to have to batten down the hatches, get leaner, and work to get profitable, but the venture backed startups are going to get more time to get through this process than those that are not venture backed. Here’s why.
Venture capital firms are largely flush with capital from sources that are mostly rock solid. If you look back at the last market downturn, most venture capital firms did not lose their funding sources (we did at Flatiron but that’s a different story). If you are an entrepreneur that is backed by a well established venture capital firm, or ideally a syndicate of well established venture capital firms, then you have investors who have the capacity to support your business for at least 3-5 years (for most companies).
Venture capital firms will get more conservative and they will urge their portfolio companies to do everything Jason suggests (and more), but they will also be there with additional capital infusions when and if the companies are making good progress toward a growing profitable business.
If you go back and look at the 2000-2003 period (the nuclear winter in startup speak), you’ll see that venture firms continued to support most of their companies that were supportable. The companies that were clearly not working, or were burning too much money to be supportable in a down market, got shut down. But my observation of that time tells me that at least half and possibly as much as two/thirds of all venture backed companies that were funded pre-market bust got additional funding rounds done post bust.
So if you run or work in a startup company that is backed by well established venture capital firms, take a brief sigh of relief and then immediately get working on the “leaner, focused, profitable” mantra and drive toward those goals relentlessly.
If, on the other hand, you are just starting a company, or have angels backing you, or are backed by first time venture firms that are not funded by traditional sources, then I think you’ve got a bigger problem on your hands. It’s not an impossible problem to solve, but you have to start thinking about how you are going to get where you want to go without venture funding.
I say that because in down market cycles, it’s the seed and startup stage investing that dries up first. It happens every time. Seed/startup investing is most profitable early in a venture cycle and late stage investing is most profitable late in a venture cycle. It makes sense if you think of venture capital as a cyclical business and it is very cyclical. Early in a cycle you want to back young companies at bargain prices and enjoy the demand for those companies as the cycle takes hold. Late in a cycle you want to back established companies that need a “last round” to get to breakeven and you can get that at a bargain price compared to what others paid before you. I’ve been in the venture capital business since 1986 (that was a down cycle) and I’ve seen this happen at least three times, probably four times now.
There’s another important reason why seed and startup investing dries up in down cycles. Venture firms don’t need to spend as much time on their existing portfolio companies when things are going well. A rising market hides a lot of problems. But when things go south, they tend to become inwardly focused. I believe we are headed into a period where venture firms will spend more time on their existing portfolio and less time adding new names to it.
What entrepreneurs need to know about Founders’ Stock September 15, 2008Posted by jeremyliew in Entrepreneur, financing, founders, start-up, startup, startups, VC, Venture Capital.
When entrepreneurs start a company, there are four things they need to know about their stock in the company:
• Vesting schedule
• Acceleration of Vesting
• Tax traps
• Potential for future liquidity
The typical vesting schedule for startup employees occurs monthly over 4 years, with the first 25% of such shares not vesting until the employee has remained with the company for at least 12 months (i.e. a one year “cliff”). Vesting stops when an employee leaves the company.
Even Founders’ stock vests. This is to overcome the “free rider” problem. Imagine if you start a company with a co-founder, but your co-founder leaves after six months, and you slog it out over the next four years before the company is sold. Most people would agree that your absentee co-founder should not be equally rewarded since he was not there for much of the hard work. Founder vesting takes care of this issue.
Even if you’re the sole founder, investors will want to see your founder’s stock vest. Your ability and experience is one of the key assets of the company. Therefore, venture capital firms, especially in the early stages of a company’s development and funding process, want to make sure that you are committed to the company long term. If you leave, the VCs also want to know that there is sufficient equity to hire the person or people who will assume your responsibilities.
However, many times vesting of founders’ shares will follow a different schedule to that of typical startup employees. First, most founder vesting is not subject to the one year cliff because founders usually have a history working with each other, and know and trust each other. In addition, most founders will start vesting of their shares from the date they actually started providing services to the company. This is possible even if you started working on the company prior to the issuance of founders’ stock or even prior to the date of incorporation of the company. As a result, at the time of company incorporation, a portion of the shares held by the founders will usually be fully vested.
This vesting is balanced by investors’ desire to keep the founders committed to the company over the long term. In Orrick’s experience, venture capitalists require that at least 75% of founders’ stock remain subject to vesting over the three or four years following the date of a Series A investment.
ACCELERATION OF VESTING
Founders often worry about what happens to the vesting of their stock in two key circumstances:
1. They are fired “without cause” (i.e. they didn’t do anything to deserve it)
2. The company gets bought.
There may be provisions for acceleration of vesting if either of these things occur (single trigger acceleration), or if they both occur (double trigger acceleration).
“Single Trigger” Acceleration is rare. VC’s do not like single trigger acceleration provisions in founders’ stock that are linked to termination of employment. They argue that equity in a startup should be earned, and if a founder’s services are terminated then the founders’ stock should not continue to vest. This is the “free rider” problem again.
In some cases founders can negotiate having a portion of their stock accelerate (usually 6-12 months of vesting) if the founder is involuntarily terminated, or leaves the company for good reason (i.e., the founder is demoted or the company’s headquarters are moved). However, under most agreements, there is no acceleration if the founder voluntarily quits or is terminated for “cause”. A 6-12 month acceleration is also usual in the event of the death or disability of a founder.
VC’s similarly do not like single trigger acceleration on company sale. They argue that it reduces the value of the company to a buyer. Acquirors typically want to retain the founders, and if the founders are already fully vested, it will be harder for them to do that. If founders and VC’s agree upon single trigger acceleration in these cases, it is usually 25-50% of the unvested shares.
“Double Trigger” Acceleration is more common. While single trigger acceleration is often contentious, most VC’s will accept some double trigger acceleration. The reason is that such acceleration does not diminish the value of the enterprise from the acquiring company’s perspective. It is arguably in the acquiring company’s control to retain the founders for a period of at least 12 months post acquisition. Therefore, it is only fair to protect the founders in the event of involuntary termination by the acquiring company. In Orrick’s experience, it is typical to see double trigger acceleration covering 50-100% of the unvested shares.
If things go well for your company, you’ll find that its value increases over time. This would ordinarily be good news. But if you are not careful you may find that you owe taxes on the increase in value as your Founder’s stock vests, and before you have the cash to pay those taxes.
There is a way to avoid this risk by filing an “83(b) election” with the IRS within 30 days of the purchase of your Founder’s shares and paying your tax early on those shares. One of the most common mistakes I’ve encountered with founders is their failure to properly file the 83(b) election. This can have very serious effects for you, including creating future tax obligations and/or delaying a venture financing of the company.
Fortunately, over the years, I’ve developed a number of work-arounds (depending on the circumstances) and we can many times find a solution that puts the founder back in the same position had the 83(b) election been properly filed. Nevertheless, this is one of the first things that your lawyer should check for you.
Of course, you’ll still owe tax at the time of sale of the shares if you make money on the sale. But by then, I’m sure you’ll be able and happy to pay!
POTENTIAL FOR FUTURE LIQUIDITY
Founders’ stock is almost always common stock because VC’s purchase preferred stock with rights and preferences superior to the common stock. However, recently my law firm (Orrick, Herrington & Sutcliffe LLP) has created a new security for founders which we call “Founders’ Preferred” which enables founders to hold some of their shares in the form of preferred stock. This allows them to sell some of their stock prior to an IPO or company sale.
The “Founders’ Preferred” is a special class of stock that founders can convert into any series of preferred stock sold by the company to VC’s in a future round of financing. The founders would only choose to convert these shares when they plan to sell those shares to VC’s or other investors in that round of financing. This special class of stock is convertible into the future series of preferred stock on a share for share basis. Except for this conversion feature, this class of stock is identical to common stock.
The benefit to you is that you are able to sell your shares at the price of the future preferred round. This avoids multiple problems associated with founders attempting to sell common stock to preferred investors at the preferred stock price.
Furthermore, the benefit to the preferred investors is that they can purchase preferred stock from the founder as opposed to common stock.
“Founders’ Preferred” can usually only be implemented at the time of the first issuance of shares to founders. Therefore, it is important to address the advantages and disadvantages of issuing “Founders’ Preferred” at the time of company formation. I normally recommend for founders who want to implement “Founders’ Preferred” that such shares cover between 10-25% of their total holdings, the remainder being in the form of common stock. The issuance of “Founders’ Preferred” remains a new development in company formation structures. Therefore, it’s important to consult legal counsel before putting this special class of stock into effect.
Many VCs do not like to see Founders’ Preferred in a capital structure.
As discussed above, there are a number of issues to address when issuing founders’ stock. In addition to business terms associated with the appropriate vesting schedule and acceleration of vesting provisions, founders need to be navigate important legal and tax considerations. My advice to founders is to make sure to “get it right” the first time. Although here are many companies on the web that specialize in helping founders by offering forms for setting up companies, it is important that founders get the right business and legal advice, and not just use pre-packaged forms.
This advice should begin at the time of company formation. A little bit of advice can go a long way!
Cooley Godward seeing a shift towards a lower proportion of early stage financings September 12, 2008Posted by jeremyliew in VC, Venture Capital.
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Cooley is one of the largest and most respected law firms in Silicon Valley. It recently released its Private Company Financings Report for Q1 2008, based on the 66 completed deals that the firm worked on in that quarter. The report confirms that early stage financings have declined as a percentage of total deals, 59% of all financings, the lowest percentage since Q4 2004. Series D and later financings have increased to 19%, likely taking up some of the slack from the lack of venture backed IPOs that we have seen so far this year.
Other notable facts:
24% of financings were flat or down rounds, about the same proportion as recent quarters
46% of Series A deals have participation* beyond 1x liquidation preference, increasing up to 66% of Series D and later deals.
65% of deals have a drag along feature, continuing the upward trend that is making this more of a standard.
Interesting reading for both investors and entrepreneurs.
Looking to raise capital? Send an executive summary. June 4, 2008Posted by jeremyliew in start-up, startup, startups, VC, Venture Capital.
Rick Segal’s (a VC in Canada) recent post made me smile with recognition:
It’s around 2a in Toronto, midnight here in Edmonton. 260 summaries, plans, ideas, and virtual napkins are staring at me with an evil grin.
It can feel like it is hard to get a VC’s attention. I’d like to think that it isn’t because we’re bad people, and it isn’t because we’re lazy people. But we do get pitched a lot, and the ambient noise level is high. The quote above goes some way to explaining why a VC can’t give an hour to every entrepreneur who wants to meet. So what is the best way to break through the noise?
I agree with Venture Hacks’ advice on what to send an investor when they say:
Summary: An introduction captures an investor’s attention, but a great elevator pitch [executive summary] gets a meeting. The major components of the pitch are traction, product, and team.
Venture hacks goes on to advise on what not to send an investor, and I agree again:
Summary: Don’t send long business plans to investors. Don’t ask for NDAs. Don’t share information that must remain confidential.
So how do you write a good executive summary that can break through the noise? Garage.com has an excellent summary (italics mine):
The job of the executive summary is to sell, not to describe.
The executive summary is often your initial face to a potential investor, so it is critically important that you create the right first impression. Contrary to the advice in articles on the topic, you do not need to explain the entire business plan in 250 words. You need to convey its essence, and its energy. You have about 30 seconds to grab an investor’s interest. You want to be clear and compelling.
Garage.com breaks down the 9 elements of a good executive summary as follows:
1. The Grab
2. The Problem
3. The Solution
4. The Opportunity
5. Your Competitive Advantage
6. The Model
7. The Team
8. The Promise
9. The Ask
If you’re looking to raise capital, I suggest that you read the whole thing.