David Cummings on Startups

Category: Investing

  • The 27x Rule for Venture Fund Aggregate Investment Exits

    Jason Lemkin has a great post up titled Why VCs Need Unicorns Just to Survive. The idea is that even with a standard-sized venture fund, say $100 million, the aggregate exit values of the investments needs to be $2.7 billion. Here’s how the math works, from his post:

    • $100M fund
    • Goal is $400M in returns before fees
    • Average ownership stake of 15%
    • Roughly 15 investments
    • $400M / 15% = $2.7 billion

    So, the 15 companies need to sell for an aggregate of $2.7 billion with the fund holding a weighted average equity position of 15% to generate $400M in returns. The 27x rule for venture fund aggregate investments means that whatever the venture fund size, multiple it by 27 to get the rough scale of all exits combined required for the fund to do well. If it’s a $50M fund, it needs $1.35 billion in aggregate exits. If it’s a $200M fund, it needs $5.3 billion in aggregate exits. The big wildcard is the average ownership stake, but the 27x rule is directionally correct

    What else? What are some more thoughts on the 27x rule for venture fund aggregate investment exits?

  • Unicorn Valuations aren’t the Same as Public Market Valuations

    Fenwick & West, one of the top law firms for high growth tech companies, has a great new post up titled The Terms Behind the Unicorn Valuations. With so many tech startups raising money at valuations of a billion or more, it’s clear we’re in boom times, but it’s also clear that many people don’t understand that the valuations of these unicorns aren’t the same as the valuations we see in publicly traded companies. Why? The investors in these companies get special preferred stock that has a number of additional protections, and in exchange, they invest at a higher valuation. Put another way, if the stock was common, like is normally associated with a publicly traded company, the valuations would be significantly lower.

    Here are a couple terms that make the preferred stock more valuable than common stock, according to the survey:

    • Acquisition Protection Terms – If the company is sold at a value lower than the investment valuation, the investors get all their money back, even if their percent ownership represents a smaller amount of money (e.g. if an investor puts in $100M at a $1B valuation and owns 10%, then the company is sold for $500M, instead of getting $50M in the sale, the investor gets their $100M back, even though that’s 20% of the sale).
    • Future Financing Protection Terms – If the company raises money at a lower valuation in the future, the existing investors get an increased ownership position in the company that represents the previous investment amount relative to the new valuation (e.g. if the company raised $100M at a $1B valuation, that’s 10%, but then if they went out and raised another $50M at a $500M valuation later, the investors that put in the $100M in the previous round would now have 20% of the company instead of 10%, and the non-investors like the entrepreneurs and employees would be diluted).

    For a great story that shows how deal terms matter more than valuation, read Heidi Roizen’s How to Build a Unicorn from Scratch – and Walk Away with Nothing. Due to these specials terms, and others, the valuations for unicorns aren’t the same as public market valuations as the investors get a number of protections that aren’t normal.

    What else? What are some other terms tech startup investors often get that make the valuations between private and public companies difficult to compare?

  • Understanding Investor Pro-Rata Rights

    One area that doesn’t seem well understood is how investor pro-rata rights work. When an investor buys a portion of a startup, whether as an angel or VC, they almost always also get the right to invest in subsequent rounds to maintain their same percentage of ownership. If the investor doesn’t continue to put in more money each time the company raises a round, the percentage of ownership in the business goes down. Here’s how it might look:

    • Angel investor puts in $100,000 for 5% of a startup as part of the seed round ($2 million post-money valuation)
    • Startup raises a $3 million Series A at a $7 million pre-money valuation and a $10 million post-money valuation
    • If the angel investor doesn’t invest any additional money at the Series A, the 5% ownership is reduced to 3.5%
    • If the angel investor does want to participate pro-rata, the angel investor has to put in $150,000 (5% of the $3 million), and thus still own 5% of the company, but has now invested a total of $250,000

    This process of needing to invest more money in each subsequent round to maintain ownership continues until the company goes out of business, is acquired, or goes public. Additionally, ownership, as a percentage, is still likely to be reduced, regardless of subsequent rounds, by things like new stock option pools. Ownership, as a percentage of a startup, is a moving target, and investors participating pro-rata, or not, is an important component.

    What else? What are some more thoughts on investor pro-rata rights?

  • Angel Liquidity Fund Idea

    Continuing with yesterday’s post on the Pooled Angel Investor Liquidity Fund Idea, there’s another variation that’s more focused on making money as a fund while still helping with the liquidity problem that angels have in the market. Instead of angels putting a small portion of their equity into a pooled fund, the idea is for a dedicated fund that buys stakes at a discount from angel investors once their investments have raised money from institutional investors.

    Here are a few ideas for an angel liquidity fund:

    • Focused on startups that raise institutional capital (much like Silicon Valley Bank and Square 1 Bank generally do for lines of credit)
    • Purchases equity at a discount to the most recent funding round (e.g. a 50% discount due to limited rights, lack of liquidity for the asset, etc.)
    • Only partial liquidity for the angel investor as it’s important for the angels to still have a stake in the startup
    • Geographic and/or industry/vertical specific (e.g. B2B Software-as-a-Service startups)

    Here’s how an ideal example might work. An angel puts $100k into a startup for 5% of the startup, thus a $2 million post-money valuation. Then, 18 months later, the startup raises $3 million from institutional investors at a $10 million post-money valuation. The angel investor wants some liquidity and owns roughly 3% of the $10 million company after dilution (assuming the angel didn’t participate pro-rata in the round). On paper, the angel’s investment is worth $300,000, and the angel would like to get their original principle back, so they sell $200,000 of paper value for $100,000 in cash to the fund, while still owning $100,000 of paper value in the startup. Now, the angel investor is more likely to invest in additional startups and still has good upside from the existing investment.

    Providing liquidity to angels and making money as a fund are both attainable, especially when more of the angel investments raise institutional rounds. This method might reduce the rate of return for the angel investors, but that’s expected due to increased liquidity.

    What else? What are some more thoughts on the angel liquidity fund idea?

  • Pooled Angel Investor Liquidity Fund Idea

    One of the biggest problems as an angel investor is the lack of liquidity due to long time horizons and so few exits outside of the San Francisco Bay Area. Meaning, if you invest $25k in a startup today, and follow on with another $50k or $75k over the years, there’s a good chance you won’t see a return for 7-10 years, if ever. Who wants to invest a large sum of money and have no way to access any of it for a decade? Seems like a tall order, and is one of the reasons it’s so hard to raise angel money outside of friends and family that just want to help.

    Here’s an idea for a pooled angel investor liquidity fund:

    • A group of angels, say 10-20, that invest at least $100k per year, ideally in non overlapping investments, agree to join a fund that holds 20% of the equity of their investments (e.g. invest $50k for 5% of a startup and 20% of that equity, which is 1% of the startup, goes into the liquidity fund)
    • Contributed equity is valued at the valuation of the most recent round with no modifications for preferred preferences, cumulative dividends, etc. so as to keep things simple
    • As exits occur, which is both more likely and more frequent due to having so many more deals, especially if there are 10-20 new investments per year, everyone in the liquidity fund will see more cash cycle through the community
    • Much like a mutual fund, there’s benefit in having a more diversified portfolio, but there’s still direct picking of startups and strong upside for the occasional homerun

    Why not just invest in a venture fund and get the benefit of pooled capital? Venture funds make a limited number of investments and still have no liquidity in the short run, just like angel investing.

    Unanswered questions about the pooled angel liquidity fund idea include who manages it, how are they compensated, and how long is the ramp up period until the fund starts seeing cash distributions on an annual basis. Regardless, there’s a desire for more liquidity as an angel investor and this is one idea to address it.

    What else? What are some more thoughts on the pooled angel investor liquidity fund idea?

  • Do VCs Add Value?

    Charlie O’Donnell from Brooklyn Bridge Ventures has an interesting piece up titled VC Value add: Why it probably doesn’t matter, but I try anyway. Charlie, having been at First Round Capital and Union Square Ventures, which are two of the premiere venture firms, talks about how he believes 99.999% of billion dollar exits are due to the founders, and nothing to do with the investors. That’s an impressive statement from someone who’s been around the best in the business.

    Personally, I haven’t seen a billion dollar exit, so I don’t know what it’s like at that scale. As for going from idea stage to seed to early to growth, I have seen a number of good examples. Here are a few areas where investors should add value:

    • People – Great talent is one of the top challenges for entrepreneurs, and investors should have a strong network of people.
    • Psychologist – Building a great company requires making a number of hard decisions, and sometimes the best help an entrepreneur needs comes from a good listener that asks the right questions.
    • Processes – Growing a business is hard, especially as more employees are brought on. Putting in processes and procedures, like a Simplified One Page Strategic Plan every quarter, is part of every entrepreneur’s maturation process.
    • Fundraising – One round of funding doesn’t guarantee another, and helping portfolio companies raise the next round of funding is an important role.
    • Introductions – Making introductions is the most important value add for investors, especially in regards to helping find customers, partners, and employees.

    I do believe the right investors can add significant value. Can they influence the outcomes on billion dollar exits? I don’t know. Can they be the difference between building a successful business and not building a successful business? Absolutely. Some investors add value and some don’t, and as an entrepreneur, the key is to figure that out in advance of partnering.

    What else? What are some more thoughts on VCs adding value?

  • Investor IRR on Paper to Raise Another Fund

    Recently I was meeting with a venture investor talking about the market and opportunities at the Atlanta Tech Village. He had just joined a new partnership, so, naturally, I asked what happened at his previous firm. He said the firm had made the targeted number of investments, but didn’t have the required internal rate of return (IRR) to raise another fund, and was desperately trying to make the existing investments more successful.

    Here are a few thoughts on investor IRR on paper to raise another fund:

    • Current boom times, where hot startups raise more money at ever higher valuations, makes the paper returns for the earlier investors excellent, even though some of those startups won’t be able to grow into their valuation
    • Investor returns, outside of exits or selling a piece of the investment, are measured via mark to market, such that the main way to get a new market price is by raising another round of funding, hence the VC desire to raise more money at a higher valuation
    • Some funds, that had poor overall returns, but good returns for a select number of the partners, market their next fund based on the returns on the partners that did well, and not the overall fund numbers
    • Most funds don’t achieve their stated goal of returning three times the money in seven years, which is 17% IRR (see Demystifying Venture Capital Economics), and thus can’t raise another fund

    When talking with investors, it’s important to understand the firm dynamics, especially where they are in their fund lifecycle. Also, note that returns on paper, not necessarily exits, are needed to raise another fund.

    What else? What are some other thoughts on investor IRR on paper to raise another fund?

  • More Venture Capital vs More Local Venture Capital

    One of the commonly repeated phrases by city leaders is that we need more venture capital in the region. Partly, the statement is conflating the desire for more money to come to the region (presumably from the limited partners in the fund that invests) with the desire for more of the financing in successful local startups to be local money (e.g. local VCs are more likely to have local limited partners). So, a) we want more successful startups, b) we want more venture capital, and c) we want the venture capital to be local, if possible, so that more of the proceeds from the winners stay local.

    Here are a few thoughts on more venture capital vs more local venture capital:

    • More venture capital, in general, will come with more successful startups (entrepreneurs need to come before the money comes)
    • Venture capitalists can be shown good startups in a region, but they’re only going to invest if they believe that a startup is going to deliver the best return compared to all other startups evaluated (e.g. if a VC from California invests in a startup in Atlanta, it’s because the Atlanta startup is going to make them more money than the startups they looked at in California)
    • Local venture capital is going to be smaller dollar amounts as firms build up their track records, and only after many years (decades?) of success, will local firms be able to raise and invest the much larger sums we’re seeing growth and late stage startups raise

    Wanting more venture capital invested in a region is different from wanting more local venture capitalists. Regardless, both will happen with more successful startups and outsized returns from investments in those startups. More venture capital starts with more success stories.

    What else? What are some more thoughts on more venture capital vs more local venture capital?

  • Escalating Carried Interest for Venture Investors

    In a typical venture fund, the venture capitalists (VCs) have a 2% annual management fee and earn 20% of the profits (called 2 and 20). That is, 2% of the value of the fund (e.g. $2 million per year for a $100 million fund) is used for salaries, office space, administration, and other expenses for a period of time (e.g. seven years) before shrinking and eventually disappearing. Then, assuming the fund is successful, the VCs receive 20% of the money generated after the investors get their principal back, including the money spent on management fees (e.g. turning a $100 million fund into $300 million in returns results in the VCs getting $40 million in profits, or carried interest).

    Now, the ultra successful VCs know that there’s much more opportunity in earning a larger piece of the profits, and they often command 30% of the carried interest, while waiving management fees because they’re confident and have already been successful (e.g. this would be 0 and 30). Well, last month I heard of another wrinkle that I hadn’t encountered before: escalating carried interest for clearing higher return hurdles. Meaning, if the VC returns even more money, they’d get an even higher percentage of the profits. In the example I heard, the institutional investor received 70% of the profits after the fund returned five times the capital (e.g. a once a $100 million fund generates $500 million in returns, the VCs would get 70% of everything past that instead of 20 or 30%).

    For venture investors with a strong track record, and amazing returns, the opportunity to make even more money comes from escalating percentages of carried interest based on results.

    What else? What are some more thoughts on escalating carried interest for venture investors?

  • The Tech Square Ventures Model

    Urvaksh broke the news on Friday about a new $10 million seed fund called Tech Square Ventures run by Blake Patton. Atlanta has a dearth of seed stage, high risk capital, so this is great for the city. Blake is an experienced operator who is well-regarded in the startup community, having run several venture-backed companies, making him an ideal person to lead a new fund.

    From an entrepreneur perspective, I think it’s important to understand how a $10 million seed fund typically works:

    • Capital is committed but not sitting in the bank (it has to be called from the investors, often at a rate of 20% per year for five years)
    • 99% of the capital is from investors and 1% is from the partners
    • 2.5% of the total fund amount is made available for the first five years for operating costs (e.g. $250,000/year to pay for salaries, office space, legal, accounting, travel, etc.) with a reduced amount for the next five years and nothing beyond 10 years
    • Partners receive 20% of the profits (carry) after the fund and all money used for annual operating costs have been returned
    • 1/3 of the money for initial investments and 2/3 of the money for follow-on investments (e.g. when a $1 is invested, $2 needs to be saved to invest in some of the companies at a later date as they grow)
    • Example investment approach:
      15 initial investments of $250,000 each = $3,750,000
      5 of the 15 investments show promise and an additional $6,250,000 is invested in those five
    • Target investor return is three times cash on cash in seven years, meaning take the $10 million invested and turn it into $30 million

    So, my guess is Tech Square Ventures will make somewhere in the neighborhood of 15 investments over an initial 3-4 year period, with most investments providing little to no return and 2-3 investments providing almost all the returns.

    I’m excited for Blake and want to see Tech Square Ventures become a successful establishment in Atlanta.

    What else? What are your thoughts on the $10 million seed fund model?