Professor Raiton’s Inside Perspectives: Entrepreneurship, Creativity, Innovation

Inc. has a fun feature this month in which ten highly successful entrepreneurs reminisce about the early days of their business. Nuggets of wisdom easily digestible in five minutes or less:

1. Gordon Segal - Crate & Barrel
2. Richard Tait & Whit Alexander - Cranium
3. Frank Perdue - Perdue Farms
4. Elon Musk - Tesla Motors / Space X / SolarCity
5. Robert Redford - Sundance
6. Mary Kay Ash - Mary Kay Cosmetics
7. Ben Cohen & Jerry Greenfield - Ben & Jerry’s
8. Jerry Yang - Yahoo
9. Hyrum W. Smith - Franklin Covey
10. Bill Gates - Microsoft

By Scott Austin, WSJ

Last August, Hewlett-Packard Co. signed a letter of intent to pay $360 million cash for LeftHand Networks Inc., a venture-backed provider of storage systems. A few weeks later, Wall Street’s collapse sent the economy in a tailspin and threatened to knock the screws out of the deal.

But after a two-week pause the two sides got back together and in November closed the acquisition on the same terms. Asked how LeftHand was able to command the same price despite the uncertainty created from the financial markets, an investor in the company said, “Maybe it’s because every Sunday I went to church and lit candles. Faith and religion are very important in the sale process.”

Jokes aside, LeftHand was able to hold its ground because it had proven itself valuable well before Hewlett-Packard offered to buy it. H-P had been reselling LeftHand’s software on some of its servers for nearly three years, and realized it couldn’t do without it.

The deal signifies the importance of setting up strategic relationships with possible acquirers, especially in this environment, said the aforementioned investor, Matthew McCall, a managing director with Draper Fisher Jurvetson Portage Venture Partners.

“When your hair’s on fire as a corporation, you’ll try anything to make the pain go away,” he said. “Now’s a great opportunity [for start-ups] to enter partnerships, distribution agreements, and dialogues with larger corporations.”

McCall was on hand at the National Venture Capital Association’s annual meeting in Boston last week to provide some pointers on how start-ups can position themselves effectively for a possible exit. McCall, who says his firm has scored 10 exits in the past 18 months, offered a few “key elements” that have helped his portfolio companies exit the past couple of years:

-Form a strategic relationship with a potential buyer. “Companies that have been successful in this enviroment are great at identifying who the strategic players are out there that would rather see you alive versus dead. Some of our portfolio companies are aggressively approaching them as a sugar daddy, as a protector in the market place. They’re going to them and saying, ‘We’re going to get a production line out for you, but getting lease financing is very difficult, would you do that for us?’ And we’re seeing some of these guys come up with corporate lease lines for them or helping guaranteeing those lease lines.”

-Look at it from the acquirer’s perspective. “Too many people try and sell from the position of fear. Especially in this marketplace, instead of saying, ‘How can we sell this?’ you need to get into their shoes and say, ‘Why do they need to buy it?’ One of our most successful sales in the last year happened because this was a critical piece of the buyer’s portfolio. You could see this was a hot part of the market, that they didn’t have a strong position in it and there are two or three competitors. If you can identify that and position it accordingly, you’re in a great position.”

-Identify the alternatives. “If you’re the clear superior company in the market and there are no alternatives, you’ve got leverage. If you’re the No. 2 or 3 technology out there, you can push as hard as you want, but they’re going to push back on you. And then at the end of the day they could buy one of your competitors and could really put you in a bind.”

-Make sure at least two mortal enemies are bidding on your start-up. “We had a company that was looking to sell, and went to a potential acquirer and said, ‘If you don’t move now, so and so will.’ They said, ‘Go ahead sell to them, we’d love to kick their ass in the market.’ About three weeks later we engaged their mortal enemy - the two had a Coke/Pepsi type of relationship. Two weeks later, we signed a letter of intent and closed it in six [weeks], at twice the original bid.”

Luke Timmerman 

Biotechnology by its nature goes through booms and busts driven by hope and fear, but now the industry is really in deep trouble. That’s the big headline coming out of this year’s Ernst & Young annual biotech survey, Beyond Borders.

Common sense would tell you that in a global economic meltdown, where mainstays like Citigroup hang by a thread, investors might not want to park their capital in an industry in which 90 percent of product candidates fail. Not to mention that, it also takes hundreds of millions of dollars and a decade or more to determine who the real winners are in developing new drugs. So it should come as no surprise that biotech companies in the U.S. and Europe raised $16 billion last year, a whopping 46 percent drop from the prior year, according to the Ernst & Young report.

(Read More)

From Seth’s Blog by Seth Godin

A business model is the architecture of a business or project. It has four elements: 

1. What compelling reason exists for people to give you money? (or votes or donations)
2. How do you acquire what you’re selling for less than it costs to sell it?
3. What structural insulation do you have from relentless commoditization and a price war?
4. How will strangers find out about the business and decide to become customers?

The internet 1.0 was a fascinating place because business models were in flux. Suddenly, it was possible to have costless transactions, which meant that doing something at a huge scale was very cheap. That means that #2 was really cheap, so #1 didn’t have to be very big at all.

Some people got way out of hand and decided that costs were so low, they didn’t have to worry about revenue at all. There are still some internet hotshot companies that are operating under this scenario, which means that it’s fair to say that they don’t actually have a business model.

The idea of connecting people, of building tribes, of the natural monopoly provided by online communities means that the internet is the best friend of people focusing on the third element, insulation from competition. Once you build a network, it’s extremely difficult for someone else to disrupt it.

As the internet has spread into all aspects of our culture, it is affecting business models offline as well. Your t-shirt shop or consulting firm or political campaign has a different business model than it did ten years ago, largely because viral marketing and the growth of cash-free marketing means that you can spread an idea farther and faster than ever before. It also makes it far cheaper for a competitor to enter the market (#3) putting existing players under significant pressure from newcomers.

This business model revolution is just getting started. It’s’ not too late to invent a better one.

From Startable by Healy Jones

One of the more common types of securities used by venture capitalists is the participating preferred stock. This preferred stock is an accepted part of the startup financing landscape, although it has some pretty significant impacts on the value of the common stock (i.e. the stock owned by management and employees of the startup) at an exit. In particular, participating preferred stock can significantly impact the return profile of an investment for a venture investor at a smaller exit value. Exits have shifted from IPOs, where participating preferred holders usually are forced to convert to common shares, to smaller M&A exits, where participating preferred holders have certain… special privileges. (See my recent post on VC backed exits in Q1 2009.)

Anything that provides extra return to a VC at an exit takes return from the founders, so it is important for entrepreneurs to understand participating preferred stock and its impact on the exit value of the common stock.

The one point that I would like startup CEOs to take away from this post is that:

The type of security your venture capitalist purchases will have different ramifications based on the size of your exit.

First of all,

What is participating preferred stock?

Participating preferred stock:  Preferred stock where the investor receives back their invested principal (plus any accrued dividends) before common stock holders and then participates on an as-converted basis in the returns to common stock holders. In other words, participating preferred holders get their invested dollars back THEN get their % ownership in the remaining proceeds. 

I’ll run a math example down at the bottom of the page, but here is a chart showing returns to a company that raised $3 million on a $3 million pre-money valuation.* In this chart I’ve plotted the percentage of the proceeds that go to the founders of the startup based on different exit sizes, ranging from $5 million to $1 billion. The bottom axis is the exit size; the left axis is the percent of the exit proceeds going to the founders.

Note that the founders technically own 50% of the business. However, it is pretty clear that the founders get a much lower percent of the proceeds at smaller exit values when they sell participating preferred equity to the investors. 

A smart venture capitalist will usually ask for participating preferred equity. Foley Hoag’s Emerging Enterprise Center shows that participating preferred is a very standard security in venture transactions. I do not see it as “unfair” that VCs ask for participating preferred, and they can (sort of) make smaller exits more palatable for venture investors.** 

The correct trade off for participation is valuation. In fact, a very good way to think about the participating preferred equity is to strip it into a bond component and an equity component. This will effectively derive a valuation discount in the eyes of the venture capitalist. If you as an entrepreneur want a higher valuation then you may be forced to accept a participating security. 

The point is this: if you as an entrepreneur are raising venture capital, you will need to be very realistic on the exit value you think you will achieve for the business. If you think that you are going to make it to a huge exit then the participating preferred equity will have a tiny impact on your eventual returns. However, if you think a smaller exit is likely then you should think carefully when accepting a participating security.  

*Here is the quick and way-over simplified math example:

A company raises $3 million at a $3 million pre-money valuation. Thus, 50% owned by investors and 50% owned by founders. Then the company is sold for $25 million. Returns to each group are calculated below. I’m assuming that the founders do not give any of the company up to anyone else; obviously a major simplification.

If the investor owns participating preferred

Investor: $14 million = $3 million of participation + $11 million of common stock return (50% of the common return of $22 million ($25 million exit minus the $3 million that already went to the participating preferred))

Founders: $11 million (50% of the common return of $22 million)

If the investor owns convertible preferred

Investor: $12.5 million (50% of the $25 million exit)

Founders: $12.5 million (50% of the $25 million exit)

That is a pretty big difference for both the VC and the founders. The difference, as a % basis, really increases when the exit value gets lower.

**Participation also helps VCs mirror the structure of their funds. Venture capitalists do not make carry until they have returned their limited partners’ investments. The return of capital to the venture investor (and thus to the limited partner) via the participation mechanism at an investment’s exit is a lot like this carry hurdle…

By Jonathan Matsey, WSJ

For many life sciences companies, setbacks during all-important clinical trials can be a death knell. But sometimes it just means you have to go back and tweak the criteria a little.

Trial parameters are key to passing muster with the Food and Drug Administration for both drugs and devices, and companies can have setbacks with good products due to the structure and endpoints established for the study.

Take the case of PhotoThera Inc. Despite failing to meet the endpoints on its previous clinical trial, PhotoThera’s underlying technology earned it a new, $50 million venture round this week as it sets out for another round of human studies.

The company conducted a trial for NeuroThera, a non-invasive device that uses infrared lasers to treat patients up to 24 hours after an ischemic stroke. The device would be a significant improvement over existing tissue plasminogen activator drugs, which work only three hours after, or highly invasive devices.

But the company’s trial, which completed enrollment of 660 patients late last year, was broad in its inclusion criteria, including severely affected patients who were harder to treat.

“It was an all-comers trial that allowed us to get fast recruitment, said Kerry Dance, managing director at Hamilton BioVentures. “We just had a lot of people who ruined our standards.”

In the new trial, expected to take three to four years, PhotoThera hopes to gain the same statistically significant results it did in the earlier trial and be able to meet its primary endpoints. “But just by moving down to slightly less severe strokes, we would have succeeded,” said James Bochnowski, general partner at Delphi Ventures, another PhotoThera investor.

Other companies have recently been successful in raising additional cash for trial re-dos, including Angstrom Pharmaceuticals Inc., which took an additional $3 million in January to launch a new Phase II clinical trial for its lead ovarian cancer peptide treatment after the standard-of-care for the disease shifted mid-study.

And last February, Avera Pharmaceuticals Inc. took a $9 million recap to re-launch clinical trials on a drug for irritable bowel syndrome and overactive bladder after problems with a non-active metabolite.

As in those cases, it was a belief in a strong underlying technology that brought PhotoThera’s investors back. “PhotoThera has a potential treatment for acute ischemic stroke, which is a huge unmet clinical need,” said Bochnowski of Delphi, whose firm joined Warburg Pincus, the lead, De Novo Ventures, Hamilton, Solstice Capital, Vertical Group and individuals in an insider Series D.

By CLAIRE CAIN MILLER, New York Times

OVER the past few years, as venture capitalists poured money into solar companies and green technology start-ups, the mood in Silicon Valley resembled the sunny days of the dot-com boom in the late 1990s. 

All that changed this winter. Now, venture capitalists are backing off, leaving some clean-tech entrepreneurs wondering whether the next few years will feel more like the dreary days following the dot-com bust.

During the first quarter of 2009, investment in green technologies by venture capitalists, who drive a disproportionate amount of financing in new technologies, shriveled.

In the first quarter of this year, they invested only $154 million in 33 young companies, a drop of 84 percent from the last quarter of 2008 when, despite the crumbling economy, they invested $971 million in 67 start-ups, according to PricewaterhouseCoopers and the National Venture Capital Association. Investment in the first quarter of 2009 reached the lowest level since 2005, before clean technology became Silicon Valley’s newest new trend.

(Read More)

From Startup Company Lawyer by Yokum

CompStudy publishes an annual report of equity and cash compensation that provides compensation data on top management positions and Boards of Directors at private companies in technology and life sciences.  CompStudy covers more than 25,000 executives at 5,000 companies and is the largest study of its kind.

Data is analyzed by: founder/non-founder status, company revenue and headcount, geography, business segment, and number of financing rounds raised. Additional detail is provided on compensation for the Board of Directors, general organizational changes over time and other compensation trends.

The survey consists of a Web-based questionnaire, which can be filled out by a single member of a company’s executive team and takes approximately 45-60 minutes to complete.

CEOs or CFOs of startups in the US, China, India, Israel, or the UK in the technology or life science industry should consider taking the survey.   Participants who complete the survey will receive the full results at no cost. 

The 2008 results are available on Altgate and are also embedded below.

For example, below are the 2008 results for average equity granted at time of hire in IT companies:

For example, below are the 2008 results for average equity granted at time of hire in IT companies:

• CEO 5.40%
• President/COO 2.58%
• CFO 1.01%
• Head of Technology/CTO 1.19%
• Head of Engineering 1.32%
• Head of Sales 1.20%
• Head of Marketing 0.91%
• Head of Business Development 1.23%
• Head of Human Resources 0.24%
• Head of Professional Services 0.60%

2008 CompStudy Report in Technology

Is there a Microsoft of the mobile application world?

“The mobile and wireless world is exploding,” said Chip Hazard, a general partner at Flybridge Capital Partners, an early-stage venture capital firm. Apple just soared past a billion downloads, handsets are becoming more powerful and cellular networks and bandwidth is steadily improving, he said.

But from a venture capitalist’s perspective, Mr. Hazard wondered, is there a $100 million mobile application company out there or just lots of hobbyists?

That was the question Mr. Hazard posed to a panel of mobile industry veterans during Wednesday’s closing panel at the National Venture Capitalist Association annual meeting in Boston.

“I am bullish about the future for mobile for generating revenue,” said Bernard Gershon, a senior vice president with the Walt Disney Company, highlighting the popularity of Apple’s App store.

“I don’t know if iBeer will be making tons of money,” Mr. Gershon said. “But Pandora has a fantastic app experience. There’s potentially something in that space that could be interesting. Gaming is becoming more interesting too.”

Rich Miner, one of the managing directors of Google Ventures, the recently formed venture capital arm of the company, said the issue was still a murky one.

They’ll make the guy in the garage happy and some angels very happy, he said. But venture capitalists want to be able to sell the company to another company or to the public in an initial public offering to get a return on their investment. “I’m not sure those venture style exits exist,” he said.

Mr. Miner helped develop Android, Google’s mobile platform, before he stepped into his role at Google Ventures. He said having reliable platforms where developers could release their software and see if it had a viable audience was crucial. There’s no guarantee any application will be a runaway success.

But still, he said “the opportunity is there.”

From Florida Venture Blog by Dan Rua by VC Dan

The National Venture Capital Association (NVCA) annual meeting kicks off today with a great mix of sessions and speakers. At a policy level, NVCA Chairman Dixon Doll is also announcing a four pillar plan to help increase liquidity via IPOs.

Pillar I - Ecosystem Partners: consolidation and attrition has limited the number of mid-tier accounting/legal/i-banking firms who can help smaller companies reach the public markets — at least at a manageable cost. The NVCA is encouraging a new set of ecosystem participants and partnering with the largest players in the industry to do the job better.

Pillar II - Enhanced Liquidity Paths: The NVCA is endorsing alternative distribution between buyers and sellers that grows buyers and their commitment to holding long-term. One example provided was Inside Venture, which pre-screens cross-over investors who agree to hold long-term.

Pillar III - Tax Incentives: From globally competitive capital gains rates, to carried interest taxation, to one-time IPO-related tax incentives; the NVCA advocates a suite of tax initiatives that will encourage investment and company growth.

Pillar IV - Regulatory Review: Sarbanes-Oxley and a host of other regulatory moves have created various unintended negative consequences and costs for smaller venture-backed companies. The NVCA advocates a tiered approach to regulation to recognize the different circumstance of large and small public entities.

The full NVCA presentation can be viewed below. It contains a good set of data behind these recommendations, including the impact venture-backed companies have on our economy (12.1M jobs created).

NVCA 4-Pillar Plan to Restore Liquidity in the U.S. Venture Capital Industry