David Cummings on Startups

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  • VC Deal Flow and Investing Volume

    Every few months here in Atlanta someone brings up the idea that we need more venture money in town. People throw around the idea of another $100 million fund (we have about a half dozen currently) and the resulting capital that will get invested in the region. As a response, I like to point out that capital is more mobile than ever before and that entrepreneurs with traction can easily raise money. In addition to capital being readily available for proven startups, it’s always important to educate people on normal investing volume for VCs, as it is much lower than expected.

    Here’s what a typical VC’s deal flow and investing volume looks like per year:

    • Meet with 200 entrepreneurs
    • Invite 20 to pitch
    • Offer term sheets to six
    • Invest in two

    So, a typical VC only invests in two deals per year. While more local funds are good for a region, the actual number of companies funded will still be limited just by the nature of the business model. The best way to grow a local tech startup community is to produce more modestly-successful companies in a capital-efficient manner that can then go raise institutional money if they so choose.

    What else? What are some other thoughts on VC deal flow and investing volume?

  • Founder Equity Shouldn’t be Common Shares

    Back in 2006 and 2007 there were a number of articles talking about a new type of founder stock called “FF class”, named after Founders Fund. These class of shares were designed for founders that might want to take money off the table at some point before selling the company (see this VentureBeat article on Series FF). As a founder, the most common type of equity is that of common shares which don’t have any special privileges. Where common shares break down is in valuation relative to recent financing and corresponding tax treatment if you want to sell some stock.

    Investors typically buy preferred shares in the company that come with special rights (e.g. investors get their money back before other shareholders get any money), and as such command a higher valuation. When it comes to valuations, these preferred shares are often worth 3-7x more than the common shares. 409A valuations are done by third-parties to establish a value for things like employee stock options so that the valuation would hold up in an IRS audit. Any money that a founder sells shares for above the price of the common would be taxed as ordinary income instead of long-term capital gains.

    Let’s look at an example. A founder starts a company and buys common shares (founders buy into their own company for next to nothing). The startup does well and investors want to put in $1 million to buy preferred shares at a $4 million pre-money valuation (making the post-money valuation $5 million). As part of the financing, the investors are comfortable having the entrepreneur sell $100,000 worth of shares (e.g. redeem some stock for cash). Now, this is where things get difficult since the founder has common shares and not FF shares. Since the common shares are worth a fraction of the preferred shares (e.g. say 1/5th of the value for a valuation of $1 million), the founder either has to sell 5x more shares to get the $100,000 with long-term capital gains treatment or sell shares at the price of the preferred, but then pay ordinary income taxes on 80% of the proceeds and long-term capital gains on 20% of the proceeds (the delta between the value of a common share and a preferred share).

    As a founder, the solution is have a second class of shares at time of formation that are similar to common shares but have the option to convert to preferred shares in the event of redemption (taking money off the table), thus being able to be pegged at a higher valuation and being able to receive long-term capital gains for the proceeds. Founder equity shouldn’t be common stock so that founders have the option to sell shares with long-term capital gains treatment at a future time.

    What else? What are your thoughts on founder equity being a special Series FF class so that founders can receive long-term capital gains at the valuation of the most recent round?

    Note: Talk to a lawyer when considering this and make sure the lawyer has experience in it as many aren’t specialists in startups.

  • Thinking About Physical Spaces in an Entrepreneurship Center

    Over the past 18 months I’ve been approached by dozens of people that wanted information or to partner on tech entrepreneurship space. Last week I talked about 5 Tips for Building an Entrepreneurship Center. Early on at the Atlanta Tech Village we received great input from startups by opening up our building pre-renovation and using that feedback to influence our master plan.

    Here are some ideas regarding physical spaces in an entrepreneurship center:

    • Co-working – A small amount is ideal. At first we thought we’d have a significant amount of co-working space only to quickly find that once startups got past a couple people they wanted to have their own sense of identity and dedicated space. 5-10% of the total space for co-working has worked for us.
    • 4-person offices – Maximize the number of 4-person offices. This size space has the most demand and is flexible in that a two-person company can rent a private room (e.g. pay for all four desks) or an 8-person company can rent two rooms.
    • 2-6 room suites – Suites are great for companies that have 8-25+ people but most startup communities don’t need too many as the eco-systems are still fairly immature. As a company grows past 20 or 30 people there are a number of traditional commercial real estate options. At the Village, we converted several of our two-room suites into individual four and six person offices due to the demand for smaller space.
    • Phone rooms – Places for private conversations and conference calls are in high demand for companies that employ sales people and more phone-oriented team members. We have one for every 30-40 people.
    • Conference rooms – Shared meeting space is heavily used and we’ve found that one meeting room for every 30-40 people works well.
    • Event center – A large meeting space is critical for bringing the community together, both within the facility and the greater area. Our event center has proved to be even more successful than expected.

    The ideal mix of physical space at an entrepreneurship center is a function of the needs of the community. Co-working generally draws more 1-2 person startups whereas 4-person offices generally draws 3-8 person startups. An entrepreneurship center should have a number of different resources in the facility and look to foster serendipitous interactions.

    What else? What are some more thoughts on physical spaces in an entrepreneurship center?

  • Example Pro-Rata Participation for an Angel Investor

    The post from two days ago Only Doing Seed Investments Without Follow-On Funding received a number of comments and questions. One aspect of being an angel investor that isn’t well understood is pro-rata participation in future rounds. As an investor you almost always get the right to maintain your percentage ownership if you invest more money each time the company raises money (this assumes an up round where the valuation is higher than the previous round). If you don’t invest more money with each subsequent round, then your percentage ownership of the company will decrease.

    Let’s look at an example scenario for an angel investor over multiple rounds of financing:

    • Angel investor puts in $25,000 for a company that raises a $1 million seed round on a $1.5 million pre-money valuation, making the company valued at $2.5 million, thus the angel investor owns 1% of the business
    • Company makes great progress and raises a $3 million Series A at a $7 million pre-money, making the post-money valuation $10 million, and the angel investor has to write a check for $30,000 to maintain the 1% ownership (the $30,000 is part of the $3 million raise)
    • Company continues to do well and raises a $10 million Series B at a $15 million pre-money, making the post-money valuation $25 million, and the angel investor has to write a check for $100,000 to maintain the 1% ownership
    • Company is in super growth stage mode now and raises a $25 million Series C at a $75 million pre-money, making the post-money valuation $100 million, and the angel investor has to write a check for $250,000 to maintain the 1%
    • Company goes public or is sold for $250 million making the angel investor’s 1% worth $2.5 million

    Of course, this is an unusual and highly successful scenario (most cities are lucky if they have one success story of this size per year). In the end, the angel investor put in $405,000 ($25k + $30k + $100k + $250k) and earned $2.5 million (again, hypothetical). The key piece is that an angel investor who put $25,000 into a startup really had to put in a total of $405,000 to maintain that position as that’s the way to make the most money (by putting more money into the startups that are doing well). People that have $25k to put into a startup generally don’t have an additional $380k to allocate towards a single, illiquid startup investment. A general rule of thumb is to reserve 2-3x of all money invested in startups for follow-on funding. Pro-rata participation and potential dilution are important considerations for angel investors.

    What else? What are some other thoughts on pro-rata participation for angel investors?

  • Passion, Optimism, and Hard Work

    Last week I had the opportunity to attend a YPO Southern 7 conference in Cape Cod. Two of my recent posts came from the event including Three Strong Bones to be Successful and Runner, Jogger, Walker, and Sitter. Some of the speakers included Ron Clark (founder of the Ron Clark Academy), Dr. Bob Rotella (famous sports psychologist), David Marquet (author of Turn the Ship Around!), and Bruce Pearl (Auburn basketball coach). After the event I reflected a bit on the speakers and content, coming away with a renewed enthusiasm about the human spirit.

    Overwhelmingly, the speakers had the same message centered around three areas:

    • Passion – Love what you do or learn to love what you do
    • Optimism – Believe in greatness and the ability to triumph
    • Hard Work – Serious effort is required and the top performers put in the most hours

    It’s always great to hear from engaging speakers with a strong message. I was surprised to hear the same recurring theme throughout the talks, but in reflecting on them it makes complete sense. Love what you do. Believe in the possibilities. Put in the time required to be successful.

    What else? What are your thoughts on passion, optimism, and hard work being the keys to success?

  • Only Doing Seed Investments Without Follow-On Funding

    After doing half a dozen investments in the last 12 months I’ve had the chance to better formulate an investment strategy going forward. My favorite spot is seed investments as I have an opportunity to help entrepreneurs get a new idea off the ground and start the search for product/market fit (see The Four Stages of a B2B Startup). Seed investments also happen to be the area that markets like Atlanta have the most need. Once a startup has some modest traction and good metrics it’s easy to raise money. Only, there’s almost no money to help an entrepreneur get an idea off the ground.

    Now that I’ve done a number of seed investments, I’ve also been in the game long enough to see a few investments need to raise another round of financing. While I’ve participated in some of these, I’ve come to realize that I’m not interested in doing follow-on funding — I’d rather use my capital to help entrepreneurs get started and then let that initial investment ride. Like Dharmesh Shah outlines in his strategy on angel investing, I’m avoiding follow-on investments.

    I realize that participating pro-rata and doubling down on the winners is how many institutional investors generate most of their returns. Right now, I’m willing to forgo putting more money into the ones doing well in order to cast a wider net and get involved with more details. It might not make the most money but I believe it’ll have the most impact in the community.

    What else? What are your thoughts on only doing seed investments without follow-on funding?

  • Great Leaders Simplify Complexity

    Last week I had lunch with an entrepreneur that had an opportunity to work with a number of super successful business leaders 20 years ago including Jack Welch, Ted Turner, and Roberto Goizueta. Curious, I asked what it was about them that made them so successful. He said that all the great leaders were very different people, different personalities, and even differing levels of intelligence. The one thing they all had in common was actually quite straightforward:

    Great leaders take complex strategies and simplify them down into key messages and action items that everyone can follow.

    How good is an awesome mission statement if it’s too complicated and difficult to follow? What about this month/quarter/year strategy? Just think about all the complex situations that arise in business and in life. Having someone that can fully understand the situation, build a quality strategy, and get everyone on the same page, especially people at all levels of the business, is invaluable. Great leaders take the complicated and make it attainable.

    What else? What are your thoughts on great leaders being able to simplify complexity?

  • Three Strong Bones to be Successful

    Earlier today I had an opportunity to hear Dr. Bob Rotella, the famous sports psychologist, talk about his lessons learned. After sharing some excellent anecdotes and making the point that all the great athletes share the same internal belief that they can be the best (confidence and visualization), he offered up a story from 30 years ago. Bob was at a basketball camp for coaches and a famous Michigan State coach had just given a talk. A hand shot up in the audience and someone asked the coach about the key to success. Simple, the coach said, you just need three strong bones:

    • Wishbone – Dream big. Know where you’re going. Have a vision.
    • Backbone – Core strength. Do the hard things. Make it work.
    • Funny Bone – Laugh at life’s curve balls. With so many unknowns a good sense of humor is required.

    The formula is pretty simple: clear vision, strong internal fortitude, and ability to handle the ups and downs. Bob Rotella did a great job with his talk and I enjoyed the message about combining belief with work ethic.

    What else? What are your thoughts on the three strong bones to be successful?

  • Runner, Jogger, Walker, and Sitter

    Recently I had the chance to hear Ron Clark from the Ron Clark Academy give a talk on passion and energy. Ron describes the bus concept from Good to Great, where it’s important to get the right people moving in the right direction. Only, he changes it to be more like a Flinstones bus where it has a big hole cut out of the floor and people are powering it with their feet (instead of a motor). He then goes on to describe the four types of people:

    • Runner – Always pushing hard. Self-starters. Have tons of ideas. Make mistakes and continue on. It’s critical to support and help these people in whatever way possible.
    • Jogger – Does a good job and helps. Never going to get the big promotion but adds value to the team. Quality team member.
    • Walker – Sometimes goes in the right direction. Needs help and coaxing. Occasionally with great support can become jogger but not often.
    • Sitter – Doesn’t carry their weight at all. Not a good fit. Needs to find a different home ASAP.

    With startups, as the team scales from a few people to a dozen people to dozens of people, it becomes readily apparent which people fall into each of the four categories. Runners are the most important and where leaders should spend most of their time. Joggers are helpful and valuable team members, but follow and don’t lead. Walkers and sitters should almost always be shown the door. I enjoyed hearing Ron’s story and powerful message.

    What else? What are your thoughts on the idea of runners, joggers, walkers, and sitters?

  • 5 Tips for Building an Entrepreneurship Center

    Earlier today I was talking with an entrepreneur that’s working on building a tech entrepreneurship center in his city. We talked about many of the lessons learned so far with the Atlanta Tech Village and drilled into several topics. At the end of the conversation I realized it would be good to summarize some of the best practices to share with others.

    Here are five tips for building an entrepreneurship center:

    1. Community – Internal community is the most important thing, even more important than the real estate. The community needs to be curated, cultivated, and crafted.
    2. Values – Similar to the community piece, the entrepreneurship center needs to have strong core values that members adhere to and believe in. Things get terribly difficult with all the shared resources and amenities, so alignment of values is a must.
    3. Scale – The center needs to be large enough to support at least two full-time staff members and at least 50 companies (I think the sweet spot is 20,000 – 40,000 feet unless there’s tremendous demand in the community).
    4. Funding – Most startups need capital, so it’s important to address the funding piece of the equation, either with an associated fund or with strong third-party capital sources.
    5. Events – A high quality event center is critical to bring the greater community together for speakers, panels, workshops, educational programs, networking sessions, and more.

    Building an entrepreneurship center isn’t easy, but it’s very rewarding. Ultimately, for the entrepreneurship center to be a winner, it needs to increase the chance of success for the entrepreneurs. Success stories are what matters.

    What else? What are some other tips for building an entrepreneurship center?