David Cummings on Startups

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  • 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?

  • Bronto and the Big Bootstrap Exit

    Back in 2002, a year after I started Hannon Hill for content management software, I was introduced to Joe Colopy, CEO of Bronto, as he had just started a new email marketing company with Chaz Felix. Both of us were based in Durham, NC, and even with the Duke/UNC rivalry, entrepreneurs enjoy connecting with entrepreneurs. After talking briefly on the phone then, we connected again in 2008 as Bronto was one of the first Pardot customers.

    Well, last week, Bronto announced that NetSuite was acquiring them for $200 million, making it a huge exit, especially for a bootstrapped company.

    Here are a few notes on Bronto:

    • 271 employees on LinkedIn (source)
    • 2013 revenue of $27 million (source)
    • 2014 revenue of $38 million (source)
    • 18 billion emails sent per year (source)
    • Definitive agreement signed but actual closing of deal not expected until end of 1H 2015 (source)

    It’s awesome to see another big bootstrap exit and congratulations to Joe, Chaz, and the whole Bronto Nation!

  • Atlanta Startup Village #27

    Atlanta Startup Village (ASV) #27 will be held this Monday night at the Atlanta Tech Village. The Startup Village is a monthly event where five entrepreneurs give five minute pitches followed by five minutes of audience Q&A. Overall, the goal is to bring the community together and share what’s going on with fellow entrepreneurs in the area.

    Here’s are ASV’s presenting companies for Monday:

    • MotoBrain – Hardware devices that make the smart phone more connected with cars, bikes, and boats
    • AnswerRocket – Natural language queries for business intelligence questions
    • TimeCue – Online employee time clock
    • SafelyStay – Guest screening for vacation properties
    • REscour – Automated market research for commercial real estate

    Please join the meetup and come out to the event. ASV is the largest monthly gathering of entrepreneurs in the Southeast and worthwhile for anyone interested in getting involved in the startup community.

  • 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?

  • Uber Burning $750 Million in a Year

    Recently, I heard an astounding piece of information: Uber is going to burn $750 million in capital this year as part of their expansion. Considering their most recent funding announcement of $1.2 billion in equity and $1.6 billion in debt, and the idea that most funding rounds are for 18-24 months of runway, the math makes sense. Still, burning $750 million in any context, let alone 12 months, is truly incredible.

    $750 million over 12 months is $62.5 million per month (the burn rate won’t stay constant month to month, but let’s assume it does). As a fun mental exercise, here’s how $62.5 million might be spent per month:

    • $5 million on legal – With all the local and state regulation battles, I bet Uber has an army of in-house and third-party lawyers.
    • $5 million on lobbying – States and local government aren’t going to change their laws based on simple requests, hence lobbyists are hired to help accelerate the process.
    • $30 million on market managers – Each market has local staff and regional staff that manage a territory. Assuming each market costs $30,000/month, on average, for fully burdened staff compensation, that provides for 1,000 new cities, which includes international expansion.
    • $2 million on office rent – Rent is super expensive in San Francisco, and Uber now has 113,000 square feet there, not counting other cities (this amount references all cities).
    • $4 million on insurance – Even though the drivers are independent contractors, Uber still has to carry huge amounts of insurance as things, inevitably, can go wrong.
    • $10 million on driver support – Screening drivers, running background checks, training, and ensuring a great consumer experience for hundreds of thousands (millions?) of drivers is no small feat.
    • $10 million on technology – While the Uber app is straightforward, a company with such scale and complexity needs a variety of internal tools to ensure continued success, and many of them are custom.

    Other potential categories include marketing, administrative costs, financing cars, more staff, etc.

    Uber is one of the fastest growing companies of all time, and on a mission to be one of the largest logistics marketplaces in the world. Burning $750 million in a year is incredible, and, a sign of the times.

    What else? What are some other thoughts on Uber burning $750 million in a year?

  • 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?

  • Accounting Rules Will Drive Companies to Look at Shorter-Term Leases

    If a fast-growing, growth-stage startup, desperate to find great office space, signs a 7-year lease at an average of $1 million per year in rent, nothing changes to the long-term liabilities in their financials. Now, the company is on the hook for a million dollars per year. What if they downsize? What if they need more space? It seems strange that the same company, whether they have seven years left on an office lease or one year left, doesn’t reflect that huge liability somewhere, encouraging companies to sign longer leases since they’ll get lower rates and more tenant improvement allowance at the beginning, and thus making the company look better in the short-term.

    Well, the Financial Standards Accounting Board is five years into a project to change the standards around accounting for leases. While it isn’t finalized yet, the net effect is that companies are going to have to recognize assets and liabilities that come from lease transactions.

    Here are a few ideas on how more transparent recognizing of leases will affect the market:

    • Lease terms will be shorter on average
    • Companies that can commit to longer terms, and the corresponding liability, will be given more concessions by landlords
    • Furnished, short-term office environments, like the Atlanta Tech Village, will see increased demand
    • Subleases will be more aggressively reviewed (and the flip side is that companies will look to get out of their liabilities more aggressively by subleasing space)

    The amount of liabilities out there for companies with long, expensive commercial real estate leases is staggering. While a FASB change won’t cause the market to correct overnight, it will have a fundamental change on commercial real estate leases.

    What else? What are some more thoughts on accounting rule changes that will drive more companies to look at shorter-term leases?

  • The Delta Between a Startup’s General Value and the Value to a Strategic Acquirer

    Last week I was talking to a gentleman that previously ran corporate development for a large tech company. During his tenure, the firm acquired dozens of companies and spent billions of dollars on acquisitions. After talking about a few experiences, he explained one of the things people have the hardest time understanding: why strategic acquirers buy companies for much more than what it seems like a company is worth.

    Actually, the answer is very simple, especially when the company being acquired has a real business with customers and revenues. The delta between a startup’s perceived value and the value to a strategic acquirer comes down to distribution. In a word, sales. Large tech companies have massive sales teams and partner channels whereby they can add new products and significantly grow product revenue.

    Imagine a software or hardware company doing $20 million in revenue with 50 sales reps and 10 channel partners. Depending on the overall economy, size of the market, growth rate, gross margins, etc, the company might be worth 3-10x revenue. Now, an acquirer comes along and sees the startup as strategic. The acquirer has 10,000 sales reps and 10,000 channel partners. Instead of the startup being worth ~$100 million, to the strategic, based on a model that shows the the product doing ~$100 million in sales in 24 months, the startup might be worth $400 million. That’s a big delta between a $100 million valuation in the general market vs $400 million for a strategic acquirer.

    The next time you see a big valuation multiple for an acquisition, ask yourself how much faster revenue will grow under the new owner, and how that changes the value equation.

    What else? What are some more thoughts on the delta between a startup’s general value and the value to a strategic acquirer?

  • YC Asset Stripping Entrepreneurial Talent

    Over the past year at the Atlanta Tech Village, I know of at least three top notch startups that applied to Y Combinator, got interviews, and didn’t get accepted. That’s not to say these startups aren’t going to be successful. Rather, the bar is so high, and there are so many applicants, the chance of any startup getting accepted is incredibly small. But, still, there were 120 amazing startups in the most recent Y Combinator class, and there are two classes per year.

    An entrepreneur-turned-investor described Y Combinator’s ability to attract entrepreneurs from around the world as asset stripping talent from other regions. Here are a few thoughts on YC attracting amazing talent:

    • With a three month program, entrepreneurs from other cities, that might not want to move to California permanently, have a chance to try before they buy, making it much easier to see oneself staying there indefinitely
    • YC’s alumni network, from what I’ve heard from friends that have gone through the program, is powerful and valuable, such that the instant credibility and access to people is a major benefit for an entrepreneur moving to the Bay Area
    • Valuations and the size of seed rounds for YC companies are considerably higher than the market average, making access to the program even more valuable, and more desirable, as a draw for talented entrepreneurs to move from a different region

    The ability to attract incredible talent at scale is one of biggest reasons why Silicon Valley will continue to thrive, and Y Combinator is a serious contributor to that net import of talent.

    What else? What are some more thoughts on YC asset stripping entrepreneurial talent from other regions?