Lesson #103: The Evolving Venture Capital Market

Boy, how times have changed for the venture capital market in the last decade, following the dot com bust of 2000.  Here are a few of the overriding trends and facts (according to the NVCA):

-  The number of VC firms has fallen from 2,316 in 2000 to 750 in 2010
-  The mix of VC firms has polarized away from the middle (Series A & B), and towards early (seed) and later stage (Series C & D).
-  The amount of venture capital dollars raised fell from $40BN in 2007 (for 200 funds) to $10BN in 2010 (for 120 funds)
-  Although fund raising is increasing again, with venture funds raising $8BN in the first half of 2011
-  But, $6BN of which (78%) was raised by only 7 firms, raising $900MM each on average (to focus on later stage opportunities)
-  The good news is VC activity is picking up in 2011, with $8.4BN of venture investments made in the first half of 2011 (up 29% over last year)
-  With the majority of such investments largely going into consumer internet deals, up 2x over last year

So, what is driving these trends in the VC market:

-  The overall economic and financial market woes have made investors more cautious, so tougher for VC firms to raise new capital (only the creme-de-la-creme firms surviving).
-  The exit opportunities for VC portfolio companiess have become more limited--much tougher to IPO companies for big paydays at big multiples
-  Therefore, VC fund returns no longer wildly outperform the broader market (S&P 500) averages, where the risk is a lot less
-  Angel investors are better organizing themselves via regional investor networks (e.g., Hyde Park Angels in Chicago) or via global sites like AngelList, now competing with VC firms and filling the void left by the VC funds who exited the market
-  Entrepreneurs have access to more mentorship by seasoned veterans than ever before, through organized regional acceletors like Tech Stars, Y Combinator, 500 Startups, Founder Institute and Excelerate Labs acting like "startup assembly lines".
-  The costs of starting a tech startup has fallen dramatically with open source and cloud solutions (e.g., from $5MM per startup in 2000 to $50K per startup today, with techies more easily founding and funding their own businesses)
-  Therefore rapidly accelerating the number of startups in the market
-  Which are all trying to benefit from the rapid explosion of people online (from 100MM in 2000 to 2BN today).
- So, traditional VC firms are being forced to play many more earlier-stage seed deals to have a seat at the table, and hopefully get later stage financing opportunities (which is not their strength)

So, what does this all mean for the startup entrepreneur:

-  It has never been easier or more affordable to startup a new business
-  Although that creates a lot of clutter in the startup market with the good, the bad and the the ugly competing for capital and consumer attention
-  Pick an industry that is currently attractive to investors, and launch a business model that is unique, scalable and defensible to attract capital and break through the clutter
-  There are plenty of seed investors and mentors to be found, but from entirely new sources than before (e.g., angel networks and accelerators instead of venture partners), although competition is fierce to get into these programs given their success (leverage your networks to get in).
-  Many of the traditional Series A & B investors from the dot com boom days have either exited the market, or are forced to play seed-stage deals or have raised bigger funds and are now focused on later stage Series C & D deals
-  So, do your homework before calling on these funds (e.g., $1BN funds too big to get their attention, $250MM funds most likely doing seed deals just to stay competitive with angel networks)
-  Make sure you raise capital from financial partners that ultimately: (i) share your business vision and personality fit; (ii) have true expertise in your industry and stage of business; and (iii) can help you finance your way all the way through profitability, either through their own fund or via partner funds.

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Lesson #102: Protect Your Equity and Control Post-Financings

The other day, I was speaking with the founder of a recently-funded startup business.  Her founding stake had been diluted down below 20%, based on a financing of under $1MM.  This 20% stake was now subject to a four-year vesting period by the new investors (with a one-year cliff vesting period before she earned anything), instead of being free and clear.  She was replaced as CEO by a friend of the investor, who she didn't think was doing a great job or listening to her to input.  She had no voice on the board of directors, with all seats held by the new investors and new CEO.  And, now, she had to make the god-awful decision of staying with the business she founded (in a disgruntled kind of way), or walking away with no equity in the business she founded, and the disappointment she lost control of her business post a very small financing and not being able to participate in raising her "baby".

What a horrible situation to be in.  My immediate reaction was: (i) you should have gotten solid legal advice prior to executing any arrangement where you would lose control of the business--and that means from your personal lawyer, not the company's lawyer, whose job is to protect the company's shareholders (not you); and (ii) it is not worth crying over "spilt milk" at this point--what is done is done.  Your #1 goal is to make sure your equity value has the best chance of becoming valuable some day, most-likely by recruiting the best CEO leadership you can find to replace the current CEO not doing his job very well (with no ego that you need the CEO reins back--as there is a reason the current investors thought they needed to replace you).  But, if the current investors/board do not agree with you that the current CEO needs to be replaced, I would cut your losses and move on to your next gig (with valuable real-world lessons for next time), regardless of how painful and emotional that may be as the founder of the company (as you can't work in a relationship where there is no mutual respect).

I share this story with you, so you don't repeat the same mistakes made by this young, first-time CEO who didn't know any better about how best to structure deals like this.  In any scenario where you are taking in new money, do your best to: (i) get good legal advice for yourself (not the company); (ii) keep a board seat; (iii) where you can, make sure your shares are not subject to a vesting period (it is your company for crying out loud); and (iv) never give up more than 49% in your first round of professional financing.  And, as for (iii) above, there are ways to give investors the protections they want, without four year vesting periods that have you losing 100% of your equity if you quit at anytime in the first year (e.g., multiple classes of stock, founder floor stake).

What this feels like to me is the investors basically saw a good business idea, but didn't think the skills of the founder were valuable to the team.  And, they basically communicated that to the new CEO, who made life miserable on the founder to the point of her wanting to quit, and the investors basically "stole" the company.  Although, the investors may tell a different story (whom I haven't spoken with), so take everything with a grain of salt.  Always remember, professional investors may have long term objectives that are different than your own, and you need to protect yourself in all scenarios (good times and bad times).   Never look at the world through rose-colored glasses, when structuring complex deals where the odds of downside, far exceed the odds of upside.

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