Wednesday, February 28, 2007

Due Diligence

I've been through more VC meetings than I care to count. Many self select out fairly early in the process (see Me and VC). But the ones that keep going have a responsibility to the fund to check out all nooks and crannies of your business. This is typically called "Due Diligence". It starts out high level and becomes increasingly invasive until satisfactorily completed. The spin on this is that these events lift you up out of the day to day and force you to pause and put together some very good documentation, which in turn makes causes you to think more critically about your business.

I thought I'd pass along a recent DD checklist from one of the many VCs we've been engaged with. This is a fairly thorough list, but gives you an idea what to prepare for ... and it is good to be prepared as BF writes in his blog on Don't be Casual.

This one is skewed more to the tech/ops area. Others would drill more into sales pipeline and financials.

1. A review of the technology model.
2. Architecture and Infrastructure. Please supply detailed architecture diagrams. Include, software, security, database, network, ISP connection, etc.
3. Scalability and Availability. Related architecture and processes. What testing has been done? Monitoring? Failover, etc.
4. Customer Installation and Set Up. Review process, etc
5. Management and Administrative Systems. Describe the support systems you have to run the business (e.g. billing)
6. Security and Privacy. Processes and system review.
7. Information Delivery. Review processes and procedures around email and other types of delivery to customers.
8. Backup and Disaster Recovery.
9. Application Development Processes
10. Third Party relationships.
11. Title / Ownership of assets such as software.
12. Management and Organization. Please supply technology and operation groups org charts. I will will probably want to briefly sit down with a couple key people.
13. IP. Supply complete patent applications.
14. Technology costs. Technology related expenses last year and expected for this year.
15. Technology road map review.
16. Manual Operations walk thru. A day in the life of operations.
17. Operations procedures. Anything documented?

Sunday, February 25, 2007

Term Sheet Terms: liquidation preference

One of the terms common to venture capital term sheets is the liquidation preference. Liquidation preferences are used to determine in what order and how much cash goes to each series of stock in the case of a liquidity event. I believe this is almost exclusively used in the underwater case where if every series of preferred stock were to convert to common, the cash out would be less than the investment in. In these cases the liquidation preference protects the holder of the preferred series of stock and lets them take cash out at the specified terms before the junior series and common are able to participate in the conversion of equity to cash.

Later series of stock are most often described as senior to previous rounds of investment, meaning their terms take precedence over the previous rounds' terms. In some cases (for instance if the round is flat) the liquidation preference can be "para passu", in other words, at the same level as the previous round.

The specified terms for the liquidation preference instructs how much cash the series shareholders may take out before others get paid out. This term is indicated in multiples of the cash that was put into the round (i.e. 1x is equal to one times the amount put in, 2x is equal to two times the amount put in, and so on). And there's one more thing to keep your eye on and that is participation. The terms can be set to either 1) exercise the liquidation preference with no participation, or 2) exercise the liquidation preference with participation. No participation is straight forward. The investor takes their money according to the liquidation multiple specified and is done. Exercise with participation means that the investor gets the money according to the liquidation multiple specified and if there is any left over after all preferred have exercised their liquidation preferences also gets to participate in the distribution of the remaining cash.

Let's take a case as an example:

ABC corp has undergone two financings, an A round, and a B round. The A round has a liquidation preference of 1x and $2M was invested for 40% of the company, the B round has a liquidation preference of 1.5x and $5M was invested for 30% of the company. So if the company now has 1,000,000 shares, the B round holds 300,000, the A round holds 280,000, and the common hold 420,000. The company has had trouble gaining revenue traction and decides to sell to a suitor who wants to acquire the technology for $10M. To further simplify the company has no outstanding debt (which would need to be paid out before the investors) and has no money in the bank and no accounts receivable. Without liquidation preferences the series B shareholders would get $3M, series A shareholders $2.8M, and common shareholders would receive $4.2M.

If both series A and B have a 1x non participating liquidation preferences, then series B would receive $5M, series A $2M, and the common would receive the remaining $3M.

If both series A and B have a 1x participating liquidation preferences then series B would receive $5.9M ($5M + 30% of the remaining $3M), series A $2.78M ($2M + 28% of the remaining $3M), and common would receive the large payout of $1.26M (42% of the remaining $3M)

kids and technology

I am constantly amazed at what comes out of my daughter's mouth. She was talking to her Grandmother on the cell phone today as we were driving along I-70 when she lost signal. After she redialed, she told Grandma, "the phone network was probably having trouble transferring the call to a different cell tower."

I can't imagine coming up with something like that at 8 years old.

Friday, February 16, 2007

whoa, did you see that big wave wash over the prow

I just saw my page views rise dramatically today (I'm currently using StatCounter). Many of these are coming from links posted on Brad Feld's blog. If any of you get a chance to work with Brad, he's one of the most knowledgable, level headed, and entrepreneur friendly VC's I've had the opportunity to befriend in this wacky world of the high tech startup. For entrepreneurs just getting started I would highly encourage you to look into TechStars just to get to know Brad and the other outstanding people associated.

Thursday, February 15, 2007

Travails of Travel

I was in New York the first part of this week and trying to get back home to Boulder yesterday for Valentines day. There was a snow/ice storm in New York and a snow storm in Denver. Most of the flights were being cancelled and they actually closed Laguardia down yesterday afternoon. Fortunately Boingo wireless is pretty good there so I was able to get some work done ... and watch CNBC on my SlingBox. A business partner asked me today how my flight went and I shot him the following email...

6 hours at the terminal
2.5 hours on the airplane at the gate
3.5 hours in the air
1 hour drive back to my house
getting home and at least spending a couple of hours with my family on valentines day - priceless

upside was that I met Dennis Hopper who was stuck on the same flight.

Term Sheet Terms: On Good Terms

We've been actively fund raising again, so I think it's time to revisit some of the terms you will encounter in term sheets. Term sheet terms are largely market driven and reflect the availability of capital during the time you raise funds. If you're raising money in a pullback environment (like I did back in 2001-2002) time frame the terms are going to be fairly conservative and not very friendly to existing share holders. If there are a lot of investments being made, then money supply exceeds demand creating competition for deals and friendly terms to existing share holders. I think we've swung back to somewhere in the middle from the lean times of my last company and so, happily, terms are looking better these days.

The interesting negotiating terms are:

  • pre-money valuation
  • option pool size
  • liquidation preferences
  • dividend
  • seniority to previous round
  • no shop clause
  • redemption
  • drag along rights
  • anti-dillution
I'll post on a few of these in the coming days

Sunday, February 04, 2007

Me and VC

We've been meeting with quite a few venture capitalists lately in the endless quest for funding. New York, Boston, Austin, San Francisco, Seattle and back home. You start to dream about the pitch at this point. The feedback comes back. Too early, too late, too far away, market is too small, market is too broad to stay focused enough. All the usual no's that come with the territory. The one I can't stand is geography. Why would you even meet if you knew geography would be an issue? I know the real answer to that question is that it's an easy way to say no but it's also a very lame way to say no.

Please give us REAL feedback. We spend a lot of time traveling and discussing our business with you. We deserve a straight answer!

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