Lots of talk recently about structural changes in the venture capital industry with major internet companies competing with VC’s for not just series B ventures but also series A/Seed. Om’s Business 2.0 article summarizes some of the issues involved while Silicon Valley Sleuth takes a longer term view. Paul Graham has been pushing the general topic for a while, calling the VC business outdated . . . most recently in Venture Capital Squeeze. Furthermore, Yahoo’s purchase of Flikr and Delicious and the recent rumors on Riya did not help VC’s case on proving their value proposition to entrepreneurs either.
As a one-time entrepreneur, I wondered aloud whether the so call change is temporary or structural. I’ve bitched and moaned about venture capitalists from time to time (exhibit A) but always understood that venture capital is neccessary, important, and (sometimes 
) welcomed part of the ecosystem. Putting myself in the shoes of these founders, I did some fuzzy math on the alternatives these 2 “financing” options. (huge caveat, I call this fuzzy for a reason cause I’m making a lot of assumptions and they varies widely case by case . . . if my finance professors or my ex-colleagues CSFB see this they’ll revoke their association with me)
Option A - Tier One VC
Pre-money valuation- 15M
Investment - 8M
Post-money valuation - 23M
VC - 35% stake
Pre-allocated employee pool - 20%
Founder(s)/founding team stake - 45%
(doesnt look TOO bad at this point, but this is where it gets dicey)
Liquidation Preference - 1.5x
(people has been telling me that this is around the market level these days . . . better than the last bubble)
Participation - Yes
(double dipping on the preference)
Vesting - 4 years, 1 year cliff . . . founders get 1 year credit for the work they put in (again VC’s being nice)
Automatic vestiing of 1/2 outstanding shares upon acquisition
Now, if the founders chose this option they are probably assuming that in one year they can triple the value of the company and sell it off at a higher price. (no discount factors used here, I’m being really aggressive but this is a Riya-esque company I’m talking about)
A year later, the company is sold for $69M, the founders vested 2 years already + 1 year automatic vesting upon acquisition = total 3/4 of their 45% = ~34%. BUT since the VC’s have a liquidiation preference + double dip, only 69M-12M = 57M is available for the founders. 34%* 57M = ~$19M. (again this is very fuzzy since we dont know the status of the employee pool and the acquisition terms)
Final founders take - ~$19M, one year later, working hard to 3x the value of the company.
Option B - Yahoo/Google
Offer - $25M
Founders share - 100% of $25M
Time - now
Effort - none
Fuzzy math confusion - none
Obviouse choice . . . sell out to the highest bidder . . .
Unless the entrepreneurs are 1) already somewhat & rich looking for a homerun OR 2) extremely confident of their ability to get to a IPO . . . Financially, there is really no reason to go route A. Of course, there are other reasons to work with VC’s, the desire to build a lasting and great company is the ultimate goal why many of us are doing what we are doing instead of working for millions at a investment bank or consulting firm . . . We make that choice a long time ago to walk down this path, making that choice again isnt really that hard. For VC’s the ultimate value add or sales pitch to entreperneurs isnt financial returns but the desire and the means to help us achieve our dreams and goals. The venture business is changing, and I think its for the better. VC’s who specialize in dumping their entrepreneurs at the first sign of trouble and view their startups as an exercise in portfolio optimization will no longer be able to attract the best and most promising startups. . . and will eventually disappear.
With Web company startup costs an order of magnitude smaller than a decade ago, you don’t need a $8M VC investment. Hardware is cheap; software is free; distribution is easy since everyone is already networked; marketing is AdWords and blogs. So what do you need money for? Salaries and rent.
The economics may shift when you’re taking about hardware or IT security or enterprise sprockets, but it certainly doesn’t apply to Web 2.0.
Comment by Adam Trachtenberg — December 11, 2005 @ 10:01 pm
One of the most frustrating thing in the venture valuation process that I discovered is that VC’s first assume that they need 30-45% of any series A or B round to be interested in any deal . . . what this means is that whether I think my company is worth $2M or $12M, there is no way I can raise a “little” money from them to get less dilution, I’m given up ~30% whether I like it or not. Thus if I have a hot company that is being bid up, I’m almost forced to raise a boat load of money I dont need. So Adam is right . . .another reason to not raise money from VC’s. . .
Comment by Administrator — December 11, 2005 @ 10:41 pm
As someone who did these type of valuations on the venture side, I can vouch for what Will is saying here. There are a couple pieces of venture economics at work here - the limit to the number of a deals a partner can manage, and the size of the fund. This roughly gets you to an amount of money that a VC has to put to work in each deal.
Ironically, it’s not just the initial size or the IRR that matters. VCs can get in trouble delivering results for a fund if they don’t put enough money to work, and see a good multiple on it.
The problem, of course, with path B is what happens when you don’t get acquired.
I also think there is some debate about what are “the best and most promising startups”. The timeframes of VC are pretty long, and a lot of people that we thought would be shaken out by the previous boom/bust weren’t. So, I’m not sure the current “blip” of a M&A craze is really enough to change the landscape for the long term.
Comment by Adam Nash — December 12, 2005 @ 9:29 am
To GYM or Not to GYM: An Entrepreneur’s Dilemna
Today, Will over at 360 throws out some thoughtful musings related to the choice startups have of taking funding from a tier-1 VC versus an early exit via GYM [Google, Yahoo, Microsoft]. It’s worth a read directly. I’ve discussed this
Trackback by The Ponderings of Woodrow — December 12, 2005 @ 9:14 pm
I might quibble with some of your math (that’s a high pre-money you’ve got there, and even the bootstrap route would probably need some angel financing), but the basic conclusion is valid. And, most importantly, in the non-VC route, you can spend all of your time building product rather than keeping investors up to date, talking to lawyers, making sure you have D&O insurance, etc..
However, keep in mind that most companies don’t play in the Google-Yahoo-Microsoft ecosystem and even those three aren’t making that many acquisitions, so sometimes you have to prepare for the long-haul, which requires capital.
Great blog, BTW.
Comment by Naval Ravikant — December 13, 2005 @ 11:28 am
Administrator,
If you don’t want to give up 30-45% of your company, raise less money and make it absolutely clear from day one that it’s a “one-firm deal.” The actual minimum (not the MSRP
for VC ownership is 15%-20% per firm. In a competitive environment, you should be able to do a one firm deal. The other negotiable point is that employee option pool. If you already have a good CEO on board, you shouldn’t be giving up more than 10% - 15% there.
Comment by Naval Ravikant — December 13, 2005 @ 11:32 am
Naval, thanks for the insight . . . the pre-money I assumed is that VC’s are competing with GYM to get the deal done so they are streching it a little bit . . . but I’m with you that these are not mere mortal valuations
(Riya?). Since I havent raised money in a couple of years, thanks for the realtime update (and the insider info on invoice pricing)!. Good to know the employee pool is negotiable too . . . 2 years ago, it would have been hard to share/get these info . . how times have changed …
Comment by will — December 13, 2005 @ 8:23 pm