Emerging Enterprise Center Blog - Commentary and Analysis For Entrepreneurs and Startups

Since Sequoia's 56 slides of gloom and doom, a lot has been written on surviving the downturn.  Don Dodge has captured 11 items of advice from John Doerr of Kleiner Perkins.  This focus on what you need to do to survive the downturn seems healthy to me because it assumes that you can and, with some grit and determination, will survive the downturn.  And, I think most start-ups will survive.  Having said that, some will experience a lot of pain and find themselves in dire straights.  And, yes, some will get into real trouble.  By real trouble, I mean bankruptcies and personal financial disasters.  To prevent these situations from becoming worse than they need to be, you need to understand where your personal liability begins and ends.  There has not been a lot of blog advice that I have seen on these points.  You can look at one thing I have written  Liability of Officers and Directors.  Item 6 of Doerr's list is "Renegotiate all contracts including rent. You will be surprised what can be renogitated for a lower price of better terms."  I agree with this item, but you need to be forward thinking about it.  Don't avoid the landlord or the bank -- deal with them up front in a realistic way.  For example, if you promised a payment on a day -- make it.  If you can't then communicate early so the lender is not surprised.  When dealing with creditors in these circumstances you need all the credibility you can get.  Also, raising and dealing with issues early (before the landlord has so many defaults that he gets panicked) will maximize the amount of flexibility that you get from the creditor.  By way of contrast, dodging phone calls and avoiding will just annoy the lender and may lead to inflexibility.

In case you needed another signal that times are tough in the entrepreneurial world VentureWire has published and article entitled Turnaround Firms Busy As Start-Up Woes Mount. The gist of the article is as follows:

The number of aging start-ups facing a shortening runway has grown in recent months, these firms say, and some venture capitalists are losing patience with longstanding portfolio companies that have no exit in sight. That's especially true for venture firms with large funds dating back to the tech bubble years of 1999 and 2000 that need to relieve congested portfolios before reaching the traditional 10-year funding cycle.

As I have noted in the past, the number of series A financings has dropped in 2008 compared to 2007 but the number of Series B and later rounds is holding pretty much steady.   I believe this is due to continue to finance existing portfolio companies, but many of these financings are likely to be at disappointing valuations or to be inside rounds.  This article suggests the obvious -- that the commitment to portfolio companies is not infinite and, in a world without exists, will eventually come to an end.

Foley Hoag is excited to launch the Emerging Enterprise Center Blog. Here we cover topics that arise from our practice representing technology companies of all stripes, including issues facing startups, financed companies, and the entrepreneurial ecosystem as a whole. The Emerging Enterprise Center at Foley Hoag LLP is specifically equipped to work with the entrepreneurial community in tackling legal questions and complex business issues that technology companies face. Our lawyers are here to work with you as you strengthen your business plans, seek out funding, grow your business and eventually go public or merge with other businesses. We want to be your go-to source for advice and partnership during the entire process and beyond.

We also want to be a source of market analysis and insight, especially during these tough economic times. An active discussion about these topics and issues is what we’re hoping to foster so please don’t hesitate to ask questions or post your thoughts.

We look forward to the conversation.

There has been a lot of interest recently in the level of venture capital investment activity that can be expected over the near term in light of the recent meltdown in the credit and capital markets. Through the third quarter of 2008, investment activity seems to have held up pretty well, but what will the future bring? I’m no fortune-teller, but based on what I’ve been seeing and hearing, I can hazard a few educated guesses:

• There will be a slowdown in activity as investors wait for the economic picture to stabilize.
• Seed rounds and Series A rounds will continue to get done for promising companies, but at reduced valuations and with more onerous terms.
• Follow on rounds will become harder to do, and will more often be internally led.
• Down rounds will become more prevalent.
• Bridge financings will serve as the finger in the dike until denial progresses to acceptance.

One potentially positive note for emerging companies that may arise out of the current economic situation:  engineering and other technical talent may become easier to find and less costly to recruit.

Many entrepreneurs focus on pre-money valuation to the detriment of other economic terms that can be equally significant in a venture financing.  As you may have heard venture investors or others say before, "I'll let you pick the valuation as long as I get to pick all the other terms." This is because beyond the pre-money valuation, there are an infinite number of ways through other economic terms for the investors to extract their returns.

The pre-money valuation is used to determine the price per share that your investors will pay, but the idea that it is actually the valuation of the company instead of simply the customary method of determining a price per share in a financing is somewhat of a misnomer. A pre-money valuation of $5 million for a typical Series A deal on a $5 million venture investment really just means that the venture investor will be getting a 50% equity stake for the upside portion of its investment (after all the preferred terms have kicked in). For the company to really be worth $5 million pre-money in that scenario, the investor would be getting the exact same type of security (common stock) as what is already outstanding. The fact that your venture investors give you a pre-money valuation of $5 million certainly does not mean that you could sell the company for $5 million instead. In fact, as the 409A valuation models will show you, the common stock in such a situation is often valued at approximately 10-20% of the preferred. So the "real" pre-money value of the company in this scenario (at least in an "appraised value" sense) may be more like $500k to $1m.  Add to that the fact that the unallocated option pool will generally be 10-20% and come out of the pre-money valuation and you can see that the "real" valuation could be as low as even $300k in our scenario (applying a 10% common to preferred valuation and a 20% option pool).

Other key economic terms entrepreneurs should be looking at in addition to the pre-money value include:

• Does the preferred have a participation feature? If so, is it capped?
• What is the liquidation preference? Is it more than 1x? 
• What is the option pool and is it taken out of the pre-money valuation?
• What is the dividend rate and do they accrue and add to the liquidation preference?

Here are two scenarios that illustrate some of these terms. Scenario B has the higher pre-money valuation, but its pretty clear it is the less attractive offer to a startup.

Scenario A:
$5 million Series A investment
$5 million pre-money valuation
10% unallocated option pool (dilutive to pre-money)
1x liquidation preference
Non-participating preferred
No accruing dividends

Scenario B:
$5 million Series A investment
$6 million pre-money valuation
20% unallocated option pool (dilutive to pre-money)
1x liquidation preference
Participating preferred
10% accruing dividend added to liquidation preference

Right off the bat, the difference in the option pools means that the investors in Scenario B will actually pay a lower price per share and receive a larger piece of equity. In Scenario A, $1m of the combined $10m valuation is set aside for the unallocated option pool, leaving $4 million of the pre-money value for the outstanding equity of the company. In Scenario B, even though the higher pre-money valuation means a combined valuation of $11 million, $2.4 million is for the unallocated option pool, leaving $3.6 million for the outstanding equity of the company. So right off the bat, despite the higher pre-money valuation, the existing equity is 10% worse position. In our scenarios, even if all terms but the pre-money valuation and option percentage were the same, it would take a pre-money valuation of $6.667 million for the point at which Scenario B with a 20% option pool is economically equivalent to Scenario A with a 10% option pool.

I'll cover some of the other key economic terms and differences between Scenarios A and B above in future posts.

This morning  I attended a “CEO Breakfast” with Don Bulens, former CEO of EqualLogic (here's a video interview of him from YouTube), sponsored by The Massachusetts Network Communications Council. He commented on a couple of things that are recurring themes in this blog. 

Don made reference to slide 49 from the now famous (infamous?) Sequoia Capital’s 56 slide presentation of doom. This slide has a red line labeled “Death spiral” which shows a hypothetical company that does not trim its burn rate falling off a cliff to presumed extinction some time in ’09. It also has a green line that shows a hypothetical company that trims its expenses right away, then grows at a slow but steady rate and survives the downturn. Don’s point was that the same kind of thing happened at the end of the dotcom bubble. He notes that some companies did hunker down and survive. Constant Contact was an example that he pointed to.   His general advice is don't fall into the trap of thinking you will be the one who captures the market by maintaining spend -- if you don't make it to the other side you will be the red line.

Don also made reference to the difference between east coast and west coast VCs. As he put it (1) Silicon Valley “celebrates” risk taking in a way that is foreign to New England and (2) the significance of this difference of style between the two coasts is way overplayed.