Today, I was asked through AskTheVC the following question:

‘”Why don’t VCs tell you the reason why they don’t invest? Any feedback would be useful. It’s just plain rude.”

I figured that this is really a personal question, so I thought that I’d post on my personal blog, as I certainly can’t speak (or even guess) the response for the entire VC industry.

I say “no” all the time.  (My partner Brad talks about “saying no” in a great post here).  In fact, I say no to over 90% of what I’m invited to invest in immediately.  On top of this, I get several to many emails a day regarding investment opportunities. 

Time is a resource that I don’t have nearly enough of.  Therefore, if your company is not doing something that we’d invest in, I feel the best use of my time is to send a quick email saying that it’s not right for our fund.  For me to give feedback on your idea, business model, team, etc. seems arrogant given that I haven’t spent any real time evaluating your company.  I’m not trying to be rude, rather, I don’t feel qualified to give you opinions on something that I’ve only taken a short gander at.  Unfortunately time constraints don’t allow me to deeply look at companies that aren’t right for our fund. 

For the other 10% of things that I spend time on, I do try to give some meaningful feedback, but sometimes it’s easier than other times.  Sometimes, there are one or two things that I have strong opinions about which I’m happy to share.  Sometimes, there are things that I’m seeing with our own portfolio companies that are relevant to your company that I may want or not want to share with you.

Lastly, one thing that has always been tough for me to deal with is when the main issue with the company is the entrepreneur(s) themselves.  It’s not easy for me to say “I wouldn’t invest in you” and I try to stay away from that, because people change and improve over time.  But there are times when the opportunity doesn’t involve an entrepreneur that excites me and thus my feedback, generally, is lighter.

I’m sure there are plenty of VCs out there that are rude out there.  I try not to be and hopefully succeed more often than not. 

All of us in the startup eco-system hear about the “evil” down round or “cramdown” financings that happen.  These days, the noise level around this financing dynamic is increasing, not decreasing.

While most entrepreneurs worry about down rounds, I’d argue that many times the entrepreneurs and employees are the ones that come out ahead.  In most cases, while the valuation is reset, the VCs funding the round don’t want to injure the current employee base by wiping out their equity holdings.  So what’s the answer?

VCs will look first to wipe out other VCs that are not participating in the round and give additional options to the employees.  Secondly, the VCs may consider wiping out their own previous equity to accomplish the same effect.

What I’ve seen over the past 10 years is that most (not all) times, the employees end up with roughly the same amount of equity while non-participating VCs are completely taken out and participating VCs being partially diluted.  Of course, ex-employees are wiped out as well.

There are plenty of examples of these types of transaction and there are plenty of examples of ultimate success stories with these companies.  My personal favorite is Stratify, but my friend Lorenzo Carver wrote a blog post about two recent examples: Open Table and SpringSource.  He points out that these are among the best exits of the year.  It’s an interesting read.

Bottom line, a down round / cramdown isn’t the end of the world for either the company or its employees.  While still stressful and painful, don’t get too out of shape.  All could turn out just fine. 

Edwin Miller of Sullivan and  Worcester recently published an article called Time to Reboot the Basic VC Deal Structure, in which he argues that we should radically change the way VC deals get done.  In his words:

"New York Times columnist Tom Friedman recently suggested that “It’s Time to Reboot America,” meaning that the financial crisis gives us a chance to fundamentally re-examine the way government and the private sector operate. Perhaps it is also time to re-examine the basic venture capital deal structure that has changed little since the 1970s.

A related issue is bloated legal documents. Simple forms that address only realistic scenarios are desirable. Sensible legal documents do not have to paper to death every one-in-a-thousand scenario. Simple, common-sense documents are easier for all parties to understand and be comfortable with, and they are cheaper and quicker to negotiate and sign. This approach may be a competitive advantage, or if broadly accepted, would promote a better outcome for all parties."

He had me at "bloated."  For those readers of my Law Firm 2.0 series, it should not come as a surprise that I think today’s legal documents are indeed, bloated.  Edwin’s thesis that many of the terms included and negotiated in today’s financing documents are unnecessary, irrelevant and / or just plane crazy is both thoughtful and correct. 

If you are interested, you should read the article.  He addresses many of the major deal points found in VC financings.  I agree with most of his assertions, but feel compelled to push back (quickly) on a few of them.

Registrations Rights:  I couldn’t agree more that any time spent negotiating reg rights is wasted time for entrepreneurs and venture capitalists and billable hours for lawyers.  However, I have been in situations that I’ve needed demand rights on a company that blew a filing and was no longer eligible for S-3 registrations.  I’m very far away from being a public company lawyer, so perhaps this doesn’t matter any more, but did then.

Anti-Dilution Rights: I am a VC, so I’m clearly biased, but I wouldn’t agree to the termination of Anti-dilution rights.  I think they are appropriate for two reasons.  One, there are large information asymmetries between a VC and a company and no amount of due diligence will ever put a VC into the same knowledge shoes as an investor.  Second, I’ve seen situations where a new potential VC to the company (who wants to invest in a lower priced round) teams up with management to try to squeeze out an early round VC.  They promise management an option refresh making them whole and the new VC would get an outsized share of the company.  For this reason, I want the protection to protect against such opportunist behavior.

Liquidation Preferences:  Alright Edwin!  I’ll take your new paradigm.  Problem is that I don’t think that I can find high quality entrepreneurs who will agree to this.

Founder Guarantee:  I think that I’d rather keep how we operate now in that there is no guarantee of ownership, as I think that properly incentivizes management.

That being said, I love the concept of dumbing down the NVCA model documents and making things easier.  Ediwn, nice job and keep the ideas coming. 

Ever since Brad and I created our term sheet series, we’ve been regularly asked "okay, so what do some model documents look like?"

Well, today, our friends at Techstars posted their model forms of seed financing documents.

Techstars worked with Brad, myself and very closely with Cooley Godward Kronish, LLP (and specifically Mike Platt) to put together a set of “Model Seed Funding Documents” that anyone can use.

There are five primary documents in the set:

• Term Sheet
• Articles of Incorporation
• Bylaws
• Subscription Agreement
• Election Consent

Of course, these are just example documents so all legal disclaimers about usage apply (e.g. “do with them what you want, but we take no responsibility for your actions.”)  That said, I think these are a great starting point for anyone doing an early stage financing.

I regularly get questions concerning how venture capitalists value companies.  In fact, there seems to be an increase in the frequency of this question to me personally and through AskTheVC. 

It’s not an exact science.  On top of that, there isn’t a broad enough market to come anywhere near a public pricing mechanism.  (Insert joke about current public market chaos here).  VCs typically take into account many factors when deciding how to value a potential investment.  You’ll note that few of them are quantifiable into hard numbers and at the end of the day, the VC and company must agree on an exact number in order to get a deal done.  So what are some of the factors?  In no particular order, I present the following:

1. How mature the company is

What stage is the company?  Early?  Late?  Pre or post product release?  Customers?  Pre or Post Revenue?  Other major milestones?  Hopefully it’s clear that the later stage company (if all goes well), the higher the valuation. 

2. How much competition there is with other potential funding sources

More is better.  If I feel like I’m competing with other VC term sheets, then the valuation will likely be higher.  I would offer caution to not overplay this card unless you truly have another interested party.  I’ve seen this situation a number of times where the company overplays its hand and doesn’t get their fundraising done and loses face in the process.

3. Quality of the management team

With a great management team, risk is taken out of the equation.  In fact, many VCs believe (me included) that even the best idea fails without an excellent team.  The more this quality team is built out before financing, the higher potential valuation you might get. 

4. How the valuation plays into a particular VC’s investment thesis

If a VC is an early-stage investor, they’ll be used to lower valuations than someone who invests in later stage deals.  This bias will have a large effect on the process.  I’ve seen companies that have received term sheets from both types of investors at the same time with wildly different prices. 

5. How much the VC thinks the company in particular wants that VC

VCs bring much more to the table than money (hopefully).  If a company wants a particular VC to fund their company (either because of domain-specific knowledge, prestige, nice offices, etc.) the price for that particular VC may be lower than others. 

6. Numbers, numbers, numbers

Yes, the numbers matter too.  Whether it is past performance or predictions of the future, these all play in.  Revenue, EBITDA, headcount, etc. all factor highly into the process.  That being said (at least for early-stage companies) don’t believe everything your MBA professor told you about DCF and other financial analysis.  Especially at the early stage, the only thing that I know about your financials is that they are very wrong.  So the financials have limited applicability to hard number crunching but are very telling of how the management is thinking about their business. 

7. How big the market is

This one is pretty self explanatory.  Bigger equals better for valuation.

8. Potential acquirers

Again, this should be easy to understand.  If there are many natural acquirers for your company, this only helps in the valuation discussions. 

9. Competition

Valuations received by your competitors can potentially make a case for you receiving a similar valuation or at least have a small "market" to compare your company performance to.  This argument is of different importance depending on who your VC is.  Some care a lot about competitive metrics and some don’t value them at all. 

10. Current economic climate

Bad climates normally lower valuations.  It seems to effect later stage fundraising valuations more than early-stage transactions. 

11. Previous deals

A particular VC’s experiences and biases will have a large effect on valuations they will present you.  Part of a VC’s job is to be good at pattern recognition.

12.  Other

There are other things as well, including the tried and true "I know it when I see it" analogy.  Part of all of these exercises are truly black box. 

Please note that I cannot give specific advice to folks on how much their company may or may not be worth.  I only know one thing about attempting this exercise – I would be wrong.  And you would not be happy with me.

It takes our group many meetings, much diligence and market analysis in order for us to arrive at the valuations we offer potential portfolio companies and even this is not an exact science.  For me to attempt this exercise for a company that I am not deeply involved with would be futile.

At the end of the day, it’s all about getting a transaction completed and whatever that number ends up being, is a rough approximation of what the company might actually be worth at that point in time. 

Or maybe it’s completely irrelevant.    But at least you got funded.  Good luck out there.

(I feel like I could write an entire series of posts on the subject, but I think that would inject too much false precision to the discussion. Again, the majority of the factors are not easily quantifiable If you just can’t help yourself and need to see numbers, check out the Dow Jones report to see some GENERAL guidelines. You can buy the whole report here.)

Venture Capital in the Rockies is a great conference.  Every year companies from the Rocky Mountain Region present while venture capitalists from all over the country attend.  If you know of high quality candidates, check out this Colorado Startups link.

Lately, I’m being asked this question several times a day.  Sometimes its from nervous entrepreneurs looking for funding, sometimes it’s from our investors wanting to know what I’m seeing and yesterday, from my father who is evidently worried that things are so bad that I might have to move back home and into his attic.  (No worries Dad, I’m good).

Frankly, we haven’t seen any affect on our business (caveat: so far – see below).  Our investors are still making their capital calls and our insurance policies seem to still be worth something due to the government’s bailout of AIG. 

Furthermore, all our Foundry Group portfolio companies are too young to pay much attention to macro economics and are heads down building their businesses.  This isn’t to say that they are spending money as if it were 24 months ago, as each are certainly being as cash efficient as reasonable, but in general our expectations for our companies have been met or exceeded despite the meltdown.

We are still seeing interest from prospective co-investors in funding our deals and, for the moment, everything seems quite "normal" if one can ever use that word in early-stage investing. 

So what might happen if the meltdown continues "indefinitely?"  Well, since I keep getting asked, here are the doomsday predictions, although I believe we are far from that day.

1.  Angel investors will disappear.  We saw this in 2001-2003 whereas individuals, either nervous, or more cash strapped than before, exited the angel investing market.  My partner Brad likes to use the "flipping of the switch" analogy when describing this market.  Of all my predictions, this one is the most likely to happen.  This could have a material impact on startups who rely on angel funding to bridge the gap between company formation and venture investment:

2.  VCs could just stop investing.  We also saw this phenomenon after the dotcom bust and it never made that much sense to me, especially in the early-stage ecosystem, but it could happen.  Certainly the late-stage investors have slowed / stopped, but my opinion is that early-stage investors should continue to deploy capital at a roughly equivalent rate each year.   

3.  Investors in VC firms, short on cash, could default on their obligations.  This is less likely if your VC firm has institutional investors, but for VC firms with many high net worth investors (who may not longer be high net worth folks), this could happen if the liquidity crises and stock market crash continue.  In this case, suddenly VCs are either unable to invest in new companies or support their current ones. 

I think the key is for entrepreneurs to realize that fundraising will be either a little or a lot tougher for the foreseeable future.  Conserve your cash, if you have it. It’s not all doom and gloom.  Stay steady and don’t freak out like Bill Murray did in Ghostbusters (great clip, if you haven’t seen the movie in a while).

Given my discussions on Law Firm 2.0 and how to make legal services more efficient, I was happy to see someone take a stab at some model financing documents for seed deals. 

I’ve had several people ask me what I think of the Y Combinator documents.  In general, I like them.  I think they are fair and certainly would not be looked poorly upon by a venture capitalist that might fund the company down the road. 

As with any documents, there are going to be some changes to meet one’s particular needs, but I think these are as good as any from a starting point. AND NO, DON’T TAKE THIS RECOMMENDATION AS ME BLESSING THESE DOCUMENTS OR ACTING AS YOUR LAWYER.  (Sorry, I have to say that).

Good work, folks.  Every little bit helps.