VC Fund Economics

I wanted to link to this great post by Fred Wilson - Venture Fund Economics.

"When I write about venture fund returns, there are always comments and questions that lead me to believe that the economics of a venture fund are not well understood. And since most of the readers and commenters on this blog are people who work in the startup ecosystem, I think its important that the economics are better understood. So I am planning on some posts on this topic in the coming weeks."

I thought a number of my readers may be interested in the drivers of VC returns. Note that these returns are also the aggregate of the entire fund. Each individual company invested in needs to be able to return a much higher amount to get this overall performance. I delve into that a little bit here.

Rob Day, Seed Stage Capital, and Government Labs

Rob Day writes one of my favourite cleantech blogs. I think today's post is particularly compelling. In it he describes the harsh reality of why many early stage companies are too "early-stage" for an early-stage VC. This is very, very useful to understand if you are pitching to a VC, or if you are interested in government policy to support innovation. Are you listening Dr. Terry Cutler?

Non-Disclosure Agreements

Bill Snow has a great summary of why venture capital firms do not sign NDAs (non-disclosure agreements).

Here's his introductory paragraph:
Let’s take a look at one of the most common miscalculations made by early stage entrepreneurs: Asking potential investors to sign a non-disclosure agreement (NDA). In the pantheon of entrepreneurial mistakes, the NDA is right up there with the infamous line, “these projections are conservative.” Simply put, if you hope to raise money from VCs, you increase your chances of success by eschewing the NDA request. Most (if not all) VCs will not sign the darn things. There are bound to be some exceptions to this rule, but not many.

The rest of the article goes into why that is the case. However, the gist of the reasoning is that venture capitalists see a vast number of deals, and it is simply not feasible to enter into non-disclosure agreements with each of them. The liability and the potential conflicts are enormous.

It is the policy of most VCs not to sign NDAs for the business plans that they are sent. A simple poll of angel investors and VCs in Australia shows that many firms have similar policies. Yet, a large number of entrepreneurs approach me, and are adamant about having an NDA signed. Why is this?

I believe that this is due to cultural factors, bad advice, and ignorance of how the industry works. The cultural factors stem from, what I have perceived is an Australian bias that assumes that "people" (banks, investors, business partners, the government, etc.) have it in for the company. Rather than looking at what a business partner, such as a venture investor, can bring to a business (ie, maximizing the upside), an entrepreneur may be more likely to be suspicious on how the business partner can hurt the business (ie, minimizing the downside).

The second factor is bad advice. Entrepreneurs look to their advisors, such as their lawyers, or investment advisor (intermediaries) for guidance. I have been impressed by far too few of these professionals that I have seen. Most do not seem to understand the position that the venture/angel industry takes because they are ignorant to the industry's requirements. The entrepreneur then approaches the investor demanding an NDA, "because my lawyer said I needed one", and this can prevent things from moving forward.

The third factor is ignorance of the industry. This is, in part, what this blog hopes to correct. However, similar to point #2, there are few sources for Australian entrepreneurs to learn what the industry requirements are. When told that an investment firm will not sign an NDA, the entrepreneur does not have the background to understand why. However, I am optimistic that this is changing because a) entrepreneurs are becoming more sophisticated all of the time, and b) the number of sources of information for entrepreneurs is growing all of the time.

So, why the AVCAL NDA then? This comes from a difference between venture capital and later stage private equity. Although our friends in private equity have their own issues, discussed here and here.

So, to close I'd like to loop back to Bill Snow's article above. While asking for an NDA is not the kiss of death, starting an early stage raise with that discussion is not the way to lure in an investor. You control the information you release - keep the super proprietary details to yourself and only worry about disclosures once the deal has progressed sufficiently. I can pitch Google's value as an investment without disclosing their algorithm, and you should be able to do the same for you business as well.

The Hive networking event

Earlier this week I spoke at a networking event for entrepreneurs called The Hive . I was extremely impressed by the organization of the event, and I think it's a great opportunity for Melbourne based entreprenuers.

I have been looking for events like this to meet new entrepreneurs and to talk about my investment interests and there haven't been many well targeted events. There are various conferences about Cleantech and business financing, and there are various lunchtime seminars put on by government organizations (which can be quite good - especially Innovic's), however, my experiences at MIT have taught me that the most exciting startup activity happens when a bunch of really smart, really motivated people get together over a beer. This is what The Hive offers.

About 100 people were on hand to listen to me give some of my thoughts on the industry (I'll boil these down to a few blog posts in the future), but more importantly, I felt that this gave a really good cross section of those interested in starting their own companies. There was a lot of passion in the room, and that's something that I think fills me with the most optimism about the future of the Australian startup scene. If you are based in Melbourne be sure to check out future events!

How to make your company investor ready

Part of what I like to speak about are interesting technology trends - particularily Cleantech trends. However, other topics of interest for me include suggestions that I can make to potential entrepreneurs. This post is the latter.

We see a lot of variety in the deals we review here in Australia. There are the straightforward deals - smart founder, team of three or four, raised $200k of angel funding, prototype developed and some market traction with introductory customers. We put in money to unlock the full potential of the company and things can really take off. However, just as often we see the "non-straightforward" deals. These might be companies which have been operating on a shoe-string budget for ten years or more, often earning consulting revenue on the side while they try to develop their product. They may have fair amounts of debt, most of it from friends/family who didn't understand that VCs are much more comfortable with angels that hold an equity position, than debt. The company may have a smattering of different products that they have tried over the years, with varying degrees of success. There could be an attractive way forward with a new market opportunity that makes the company attractive for a VC, but given the company's history, there is a lot of baggage to get through.

So, here are my suggestions for making your company as clean as possible before approaching investors (or, at least, before entering final due diligence when the lawyer's bills are running!)

Convert Debt to Equity

One of the things investors have constantly worry about is fraud. Money that immediately leaves the company to repay debt (or to pay advisors, for that matter, if they have excessively high fees - which I would classify, in some cases, to be much more than 4~5%) makes investors very uncomfortable. The reason that the company is valued for what it is by investors is partly due to what the company has accomplished, and partly due to what the company is expected to accomplish. If the company is fully debt financed, especially by the founding members, it says that the founders don't have as strong a vested interest in the company as they would with equity, and are keen to get as much money back as soon as possible, and then participate in the gains of the company. Therefore, expect to have debts paid to founders convert to equity. Debts owed to related parties or third parties may be paid, but in this case, be sure to have clear documentation of the debts prepared to be able to justify these payments. However, if you want to make your company as attractive to investors as possible, raise equity funding from your early stage backers, not debt financing.

Have Accounting Records Clearly Prepared

If your company matches the "straightforward" description that I mentioned above there is likely to be little trading history for the company, and what is there should be simple and easy to understand. However, if you have a longer history of trading (which, arguably is a good thing), then be sure to be able to present clear accounting records documenting the company's history. If it is difficult to verify the company's trading history, if it is difficult to verify the inventory the company claims as an asset, if it is difficult to verify that the company revenues have been what is being claimed, or if it is difficult to understand the company's historic cost structure (and margins) then investors are going to be very uncomfortable. If you have an attractive story, but little documentation to back it up, investors may be interested in supporting your story, but uninterested in supporting a fantasy. Without clear records, some investors won't be interested in taking a risk, based solely on your say-so. Other investors may take the risk on your company, but they will simply discount away anything they are uncomfortable about in the valuation. To have the deal be as attractive as possible to both parties, be sure to keep good records.

Clean Up Complicated Contracts

Have a special agreement with your CTO where the company pays for her car payments? Have an contract with your suppliers where they provide better payment terms in exchange free use of your testing facility? Have you agreed with a distributer to an exclusive licence of your technology over a key geographic region? If you have bizarre agreements or contracts, either within the company, or with external parties, this just further compalicates the deal - either find ways to simplify these agreement, or, again, be able to clearly demonstrate the boundaries of the agreement to the investor - and justify why the agreement was initiated in the first place. This will help calm fears which might come when the investor reviews these agreements in the due diligence, and it will build trust that you are being upfront on the state the business and how it got there.

Remove Conflicts of Interest
Don't try to operate two businesses at once - a consulting business and a high-growth product development business, and argue that you can split your time between two businesses. When investors put their money in, they are backing the founders - and for this they want to be sure that the founders will be focussed on the success of the business. If the investors are worried about your other businesses/committments, they can be uncomfortable about proceeding. If you do have multiple businesses, or subsidaries that are unrelated to the investment that can be conflicted, or even merely distracting, then plan on disengaging yourself from these businesses before proceeding. Structure your responsibilities so that 100% of you commitment is on the new venture, and you will find investors much more interested in backing you.

A key message through all of these points is clarity, transparancy, and accountability. In all cases, show clear documentation, and be able to justify past decisions the company has made, so that the investor feels comfortable that they understand what company they are purchasing, and that they understand what the company needs to do going forward. Without this clarity you may find that the investor feels too concerned about the complicated nature of a deal, and the deal cannot proceed.

This is obviously something both parties want to avoid, so do what you can to make your company as attractive as possible, and you will be in a better position to attract investment!

Welcome to Alice Springs!

I'm here in sunny Alice Springs. I'm not kidding, the weather forecast varies from "sunny" to "mostly sunny". The high temperature is 37C, which is 98 to my US friends, and it looks like the perfect place to hold a solar conference. I'm speaking at the ANZSES conference this week. My keynote compares the fortunes of Ballard Power Systems and Sunpower and tries to compare and contrast the fortunes of the fuel cell industry ten years ago to the solar industry today.

If I can figure out how to post a powerpoint presentation, I'll put it up after I present (thanks for the tips, Shuman!). The basic gist is that the solar industry today is looking a lot like Ballard was in 1998. Both Ballard and Sunpower rose from $1b~$2b market caps to ~$6b market caps in roughly 18 months.



Both companies have had a long string of successes. Both companies are built on the premise that there is a huge market to be served (automotive for BPS and utility power for SPWR). Both companies have their hopes pinned on expected, but not yet achieved cost reductions.



So what happened? Well Ballard went from stratospheric to ex-orbital (is that a word?) between January and March 2000. The value of the company shot up to around a peak of a $15b market cap! At this time the markets had thought that Ballard's product (the Mark-900 automotive fuel cell) was ready for mass-production and the market. Over the next 2, 3, 4 years it became clear that, while the product was fantastic (full disclosure: I was a proud Ballard engineer during this time) there were just too many hurdles to getting to market. Ballard's value fell and it is now "only" a $500m company.

What's different with the solar industry and will it suffer the same fate? While it is true that the solar industry, globally, is heavily subsidized, and if those subsidies went away there would be a massive decrease in the new installations of solar, the solar industry does not face the difficult path that the fuel cell industry did. The fuel cell industry faced a huge "chicken and egg" problem - no one would buy a fuel cell vehicle without refuelling stations established - no one would establish fuelling stations without an installed fleet of vehicles. There were many other difficulties too, but let's stick with this one as it is the one which is not solvable with technical improvements. This "chicken and egg" problem prevented, not just mass-production, of fuel cells, but darn near any production of fuel cells. Fuel cell companies could not even begin to start riding the learning curve of production down to reduce costs.

Solar, on the other hand, doesn't face such a barrier. This is allowing solar energy (and here I'm just speaking of PV) to be produced in huge quantities. Each solar cell produced costs less than the cell before that. This is giving the solar energy the momentum it needs to continue to drive down costs, and then eventually compete without subsidy against other forms of electricity generation. This slow, but steady, improvement is an opportunity the poor fuel cell was never provided. Ballard's engineers built a killer product, but it was required to compete fairly with the automotive engine from day 1, and build out a supporting installed base at the same time.

So, are solar energy stocks overvalued? Perhaps, perhaps not. If I knew for sure I'd be calling my broker. However, we at Starfish feel that the opportunities in the solar industry are certainly real, and that, this time, there are real, long-term, sustainable, businesses to be built that have a decent path to market. I'm here in Alice to see if I can support any. Oh, and to soak up some sun!

Renewable Energy Conference

I just returned from Bendigo, Victoria. Bendigo is a regional city within Victoria, and one of the more successful regional centres. The conference showcased how regional Australia could benefit from a growing renewable energy industry. This reiterated how climate change should not be discussed in terms or "economy" vs "environment". Rather, addressing the full costs of carbon emissions will create tremendous opportunities for economic growth (especially in regional areas) addressing the problem.

I got to give an interesting presentation, and if I figure out how to host files off of Blogger, I'll try to post it here. A number of people seemed to really like it. I may have ruffled a few feathers in the fuel cell industry when I said that it was very difficult to make investments in the fuel cell space now after the tremendous exposure that fuel cell companies received in the last ten years. However, with my years at Ballard, and my exposure to Plug, UTC, GM and other fuel cell developers, I still am pretty confident I know what I'm talking about.

The ABC (Australian Broadcasting Corporation) interviewed me for their radio segment, which discusses portions of my talk. If you want to listen to it, it's listed here. It was great to see the enthusiasm at the conference, and it was good to meet up with some entrepreneurs. If anyone reading this blog has any questions about anything I mentioned, be sure to leave a comment and I'll try to respond.



Note: the picture and the interview (I imagine - although I suppose I provided most of the content) are copyright the ABC.

Hello to RMIT

I had an interesting discussion with business undergrads today at RMIT in Melbourne (apologies to Georgia Beattie, who I accidentally called Georgina...oops). As undergrads I was fairly encouraged that they were as interested as they were in venture capital, business strategy, and what makes a successful start-up. Very likely some of them are reading this blog, so if that's you, I hope you found it useful. I had fun talking with you.

Business Plan Tips Part 1

Part of the purpose of this blog is to help describe what issues are necessary when trying to succeed as a venture capital backed startup, with a focus on Australia and clean technologies.

So, I've started to start a series of postings called Business Plan Tips. These tips will help your business plan be more readable by, and therefore more interesting to, investors.

Today's tip is something that, when I first saw it, I dismissed it as an anomaly. However, I have since seen it four other times, and so I decided it was worth discussing, so here it is. Please do not include a "Total" column in your Income Statement.

I'll explain. If you look to the figure at the left, you see a three year Income Statement for that hot new startup, Fantastic Co. You can see modest growth in revenue and EBITDA, until glancing at the last line you see $9m in sales, with almost $5m in EBITDA. But, wait! Looking up you will see something odd. The company doesn't have $9m in sales in year four. Instead, the company has had $9m in sales across the previous three years. What does this mean?

In short, it means almost nothing. Nobody cares what the cumulative sales/EBITDA/COGS or anything else performance is over some arbitrary period of time. Putting in a Total column is just misleading, because most investors will look to the last line to see how the company is performing in the final year. Companies are valued as multiples of EBITDA, or multiples or revenue, but no company is valued as some total of previous years. I suppose the only purpose of this column would be if the company were to be liquidated at the end, but even then, the Retained Earnings figure on the Balance Sheet would be more appropriate.

So, please don't put a Total column. It's misleading. It's pointless. It frustrates the reader (and worse, once they realize their mistake, the next emotion is disappointment, because the actual final year figure is much less - even if the final year figures are reasonable, why would you ever want your reader to feel the emotion of disappointment when reading your business plan?) The goal of your business plan should be to quickly and clearly communicate your good-news story of why your company will be a success. A Total column just gets in the way.