Musings of a VC in NYC

Financing Options: Contests/Prizes/Accelerator Programs

This is the second in a series of posts about financing options for startups. By "financing" I mean obtaining cash to fund your business. There are all sorts of strategies to avoid needing funding, but this series is not about them.

I did not have this option in my original list but it was suggested so many times in the comments that I added it. This is an option that has become a lot more available to entrepreneurs in recent years. There are so many programs out there that target entrepreneurs where the winner(s) is/are awarded cash prizes or small equity investments.

The accelerator programs are probably best known to this audience. TechStars, Seedcamp, DreamIT, Startl, SeedStart, ER Accelerator, and the Fintech program are all active in NYC. Y Combinator is the pioneer of this kind of program. And there are similar programs all over the country now. These programs will require you and your founding team to relocate to a set location for around three months and participate in a program. The equity investment varies but is generally in the range of $25,000 to $30,000. The equity you will give up for this cash is usually in the range of 5-6%.

I believe the accelerator programs are excellent for teams that are just getting started and that have not had a lot of startup experience. The money is usually sufficient to fund the founding team for the three month program and often can last a bit longer. But the biggest value comes from the mentoring and the opportunity to pitch to a large group of angel investors on the last day of the program.

Contests and prizes have been around for a lot longer but there has also been an explosion of them in recent years. One of my favorite is the NYC Big Apps contest where developers compete to build the best app that uses data from the NYC open data project. The winning team gets a prize of $10,000 with no equity dilution (total prizes are $40,000). The winners of NYC Big Apps the past two years have gone on to create real businesses with funding and user traction.

The company that coordinates NYC Big Apps is called ChallengePost. They coordinate many of these contest/prize programs. When I visited ChallengePost just now, I learned that Lollapalooza is running a contest to create apps for concerts. There are $5000 of prizes available.  There is stuff like this going on all the time.

I just participated in the judging of the Disrupt NYC contest. The winner Getaround recieved a check for $50,000. Again there is no equity dilution for that cash.

You are not likely to fund your business all the way to cash flow breakeven on the money you get from an accelerator program or winning a contest (although I'm sure someone has done it). Funding startups is like climbing the stairs. You have to go up the first stair to get to the second one. These kinds of events/programs can be a great first or second stair for an entrepreneur. It can give you the money (and connections) you need to get going and get somewhere and set yourself up for the next funding source. And we will continue next week with the next post in this series.

Financing Options: Friends and Family

This is the first in a series of posts about financing options for startups. By "financing" I mean obtaining cash to fund your business. There are all sorts of strategies to avoid needing funding, but this series is not about them.

Many entrepreneurs turn to friends and family for their first funding needs. In fact, it is common for non-tech startups to raise all the capital they need from friends and family. I don't know for sure, but I would suspect that friends and family make up the largest source of funding for entrepreneurs and startups.

Friends and family financing is popular because it is easy to get a hearing from the people who know you best and they are positively inclined to say yes. But there are some negatives as well. It's tough to know how to price and structure an investment where the investors are close friends or family. You don't want to take advantage of them and they may not be sophisticated enough to know what is a good deal and what is a bad deal.

And friends and family often cannot come up with a lot of capital so unless your business doesn't need much funding, this will not be the only round you do. But friends and family can get you into business and give you some time to create value that other investors will recognize and value.

Probably the most tricky part of friends and family financing is that you really don't want to lose money that friends and family have invested with you. And most startups fail so the chances that will happen are high. I would encourage entrepreneurs who take funding from friends and family to be very clear about the risks and downside. I would also suggest only taking capital from friends and family members who can afford to lose the investment. That way, if the investment does turn out to be bad, at least you won't lose valuable relationships. Even so, it is easier on the mind to be doing a startup when your capital comes from professional investors than your loved ones.

I would recommend doing friends and family financings as convertible notes with a discount and a cap on the valuation. That way you don't have to worry about how to price the investment. A 20-25% discount from the next round is appropriate. The valuation cap is going to vary depending on the size of the raise and the size of the opportunity. I'd suggest a cap that gives the friends and family around 10% of the business if things work out. But that is just a suggestion. A 10% interest will not be appropriate for every friends and family investment.

Friends and family funding is the most common form of startup financing but also the most tricky in many ways. Be careful to do it right because there's a reason why these people will back you when nobody else will.

Financing Options For Startups

I got a bunch of great suggestions in my kickoff post on this topic last week. Based on that feedback, the series is going to look like this:

1) Friends and Family

2) Contests/Prizes/Accelerator Programs

3) Government Grants

4) Customer Financing

5) Vendor Financing

6) Convertible Debt

7) Preferred Stock

8) Venture Debt

9) Capital Equipment Loans & Leases

10) Bridge Loans

11) Working Capital Financing

This list is roughly in chronological order of how a small company might avail itself of the various financing options, but there are always exceptions. Starting a company is more art than science.

I want to do each financing option as its own dedicated post so I'm not going to start today. I will start next week with friends and family.

If you are looking for some meaty MBA Monday reading this week, I point you to Brad Feld and Jason Mendelson's awesome venture capital term sheet series, which is required reading for anyone seeking to raise venture capital.

Sizing Option Pools In Connection With Financings

We've talked about this issue before here at AVC. Investors like to require that an unissued option pool is in the pre-money valuation calculation when they put money into early stage companies. If you don't entirely understand what I am talking about here, go click on that link at the start of the post. Hopefully it will explain the issue.

This post is about how to size the option pool. Many investors just want the number to be as big as possible. They'll put 15% into the term sheet and then let the entrepreneur negotiate them down from there and maybe if you are lucky you'll get them to 10%. But there is no logic in that kind of negotiation. It is just a price negotiation disguised as something else. It is bullshit. And I see investors engage in that kind of practice all the time. It annoys me.

What I like to do, as I mentioned in the post I linked to, is agree with the entrepreneur that the option pool will have enough unissued options to fund all the hiring and retention grants that need to happen between the current financing and the next one. Then we'll do the same thing at the time of the next financing. That makes sense to me. And it is pretty easy to do.

Let's say you are raising $1mm at $4mm pre-money. And the investors want the option pool to be in the pre-money valuation. Let's say the $1mm will last you 18 months. Then you determine how many people you are going to hire in the next 18 months. If the financing is $1mm, it's not going to be that many. You probably have three to five employees already. Without revenue coming in, five employees will suck up half of that money over 12 to 18 months. So at most you are going to hire another 5 employees.

Here's a formula I like to use. Take the cumulative salaries of all the hires you need to make betwen the current financing and the next one. Let's say it is five employees at an average of $75,000. Then that number is $375,000. Then divide that number by the post-money valuation, in this case $5mm. That gives you 7.5%. That's the size of the option pool you'll need. And it is conservative because I don't recommend giving options equal to the dollar value of the annual salary of your hires. I like anywhere between 0.1x to 1x (depending on role and responsibility), with the average being in the .25x range. But early on in a company, you will need to and want to be more generous.

This approach assumes you have already granted employye equity to the existing team. Ideally they will have founders stock or restricted stock. But whatever they have, they should be holding sufficient equity to keep them happy and excited to be working in your startup. If that isn't true, you will need to add some additional equity to the pool to take care of them.

The bottom line is that sizing up option pools should not be like horse trading. It should be a science. It should be based on an option grant methodology that is driven off annual salary, and an option budget based on headcount and hiring plans. And if you do it that way, you will end up with a lot less dilution. Which is what you should always be trying to achieve.

Financing Options For Small Tech Companies

I went back and looked at all the MBA Mondays post I've written to date and what jumped out at me was a lack of discussion of financing options. Since the audience for MBA Mondays is largely entrepreneurs and the technology industry, I will frame this discussion in the context of what options are available for small tech companies. In this series of posts we will discuss the following financing options:

Common Stock

Convertible Debt

Preferred Stock

Venture Debt

Capital Equipment Loans

Leases

Bridge Loans

Accounts Recievable Financing

These are the options I've seen used most frequently in my time working with small tech companies. If you have suggestions for other financing options to be covered, please leave them in the comments and I will consider adding them to the list.

We will start next week talking about common stock and go from there.

Competition - The Pros and Cons

Today on MBA Mondays we are going to talk about competition. For most businesses, competition is a given. When I walk to work, I am often struck how many local businesses have competitors literally right across the street. Clearly competition is something you can learn to live with and still operate successfully. In fact, there are some very good things about competition. And there are some challenging things. This post will attempt to outline both.

I was having breakfast with the CEO of one of our portfolio companies recently. And we were talking about how the sales team dislikes competition but the marketing team appreciates it. That gets to the heart of the pros and cons of competition. When your company is competing for a piece of business and you have a tough competitor in the mix, you can often lose the business. The sales team, who is compensated directly on revenues, hates that. But when your competitor spends heavily on marketing its offerings and identifying the pain point both your company and their company solve, that is good for you. It generates additional demand, and some of that demand will come your way. The marketing team, which is always trying to do more with less, loves that.

There are a number of good things about competition. As described above, competitors will invest in marketing and the combined marketing efforts of a number of competitors will accelerate the development of a nascent market. It is very hard to build a market all alone. Also, when a large company enters a market, it validates the market in the minds of many who had not been paying attention to it before. That means customers and also eventual acquirers of your company. And there is nothing quite like a competitor to fire up a team. I've seen many companies start to coast a bit after they have successfully taken control of a market. Then a pesky new competitor enters, takes some business from them, and then all of a sudden the team is fired up again. All in all, I'd rather see our portfolio companies have competitors than be the only participant in the market.

But competition is challenging. First, when you have strong competitors, you will lose business to them, often frequently. That increases sales costs, time to close, and makes it harder to grow rapidly. Competitors will also spread fear and doubt (FUD) in the marketplace. This is particularly galling. I've heard all kinds of crazy nonsense spread by competitors to our portfolio companies. Some of that "crazy nonsense" stuck around for a long time and hurt our portfolio company in the market. Competitors can also strike business deals with powerful allies and gatekeepers who can make it hard and at time impossible to enter certain parts of the market. Competitors are a pain in the rear and make operating a business harder in many ways.

Competitors will also impact your fundraising and exit plans. When you have a competitor that is raising capital, it will often cause an entrepreneur to think they need to raise capital to compete. I don't think that is normally the case, but it is hard to convince an entrepreneur otherwise. That said, competitors will compete with you in the capital markets and the M&A markets. If an investor puts money into your competitor, most likely they will not invest in your company. If a big company buys your competitor, most likely they will not buy your company. This kind of competition is particularly anxiety infusing in the minds of entrepreneurs.

Very few companies will operate in a market for long without competition. Imitation is the greatest form of flattery. So be prepared for it. Make sure everyone on the team knows that competition is both good and bad. Sharpen your elbows and get ready to play tougher in the market. Get ready for cheap shots and lost opportunities. And make sure you draft on your competitors when you get that chance. And most importantly, make sure competition makes your company better. Because it should and that's almost always a good thing.

Ordinary Income vs Capital Gains

I'm wandering a bit on MBA Mondays right now. I don't have a strong view of where to take this thing next. So I'm just going to post about stuff I think people should understand until I find the next vein we can mine for a while.

Today, I'd like to talk about ordinary income vs capital gains. This is not tax advice. I am not a tax lawyer or a tax accountant. I hope both tax lawyers and tax accountants show up in the comments as this is important and complicated stuff.

When you think about the various ways you can make money, two ways predominate. You can provide services to others and get paid for those services. That is ordinary income. And you can invest in something; shares of stock, a building, a domain, and then sell it later for more. That is a capital gain.

The distinction is important, at least in the US, because these two kinds of income are taxed differently. Ordinary income is taxed at the full federal, state, and local tax rates. We live in NYC and according to our accountants, we pay a marginal fully loaded tax rate of 47.62%. That means we keep about half of the ordinary income the Gotham Gal and I generate.

Capital Gains are broken down into short term (less than one year) and long term (more than one year). Short term capital gains are taxed at ordinary income rates but long term capital gains are taxed at a much lower rate. According to our accountants, we pay a fully loaded tax rate of 27.62% on long term capital gains. That means we keep about 3/4 of the long term capital gains the Gotham Gal and I generate. That's a big difference.

It gets more complicated when you have ordinary losses and capital losses because you need to understand when and how losses and gains offset each other. The rules are complicated and ever changing and I've learned to consult my tax accountants whenever stuff like this turns up.

But the important point of this post and the one I want to bring home is not all wealth producing activity is treated equally in the eyes of the government. There is a strong bias to capital gains. I agree with that bias, not surprisingly, because I think we should have an incentive to recycle capital instead of putting it under a mattress.

If you think about wealth creation in the context of ordinary income vs capital gains, you'll quickly come to the conclusion that you can build wealth a lot more quickly with capital gains than you can with ordinary income because the tax load is so much lower. This is one of the many reasons I encourage people to think of entrepreneurship as a career. If you are a founder of a startup, your founders stock will qualify for long term capital gains if you structure it correctly when you set up the company. And when you go to the pay window (to borrrow one of my favorite JLM phrases), you will be sharing a lot less with the government and keeping a lot more.

LTV > CPA

A couple weeks ago, in a comment to an MBA Mondays post, Dan Lewis wrote "LTV has to be higher than your CPA or you're not going to make it." I asked Dan to elaborate in a MBA Mondays guest blog post on this topic and he agreed. Here's Dan's post:

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LTV stands for “lifetime value” of a customer.  CPA stands for “cost per acquisition” of a customer/subscriber.    LTV has to be greater than CPA or you won’t be able to scale – or, for that matter, survive. To demonstrate, let’s go to the video tape:

Monday through Friday, I publish a free daily email newsletter (which you can, and should, sign up for), putting to words the notion that you should – and can – learn something new every day.  Oddities, like the fact that Abraham Lincoln created the Secret Service the day he was shot, carrots used to be purple, there is only one Jewish person in all of Afghanistan, etc.  It has about 4,000 subscribers.  It’s basically a blog, sure, but I send it as an email newsletter.  Long story; one for another day.

The main costs involved – the costs of writing and editing the email – are fixed costs.   (At this point, it’s also entirely a time cost – mine to write it, and a volunteer who very generously edits it before I send it out.  But even if I hired writers and editors, the cost of producing the content is, at least in this context, a fixed cost.)  Write it once, send it to many – as many as subscribe.  It costs the same amount to write the email to one person as it does to one million (God willing!) subscribers. 

The marginal costs are, relatively speaking, minor, and consist of the fees paid to the email service provider I use, Mailchimp.  At the number of emails I send and the number of subscribers I have, it’s about a twentieth of a cent per email, or $0.05 per 1000.   Let’s say I can monetize the emails pretty easily at $1 per 1000 (or $1 CPM, as in “cost per mille” from a fictitious advertiser’s perspective), and my margin is 95%.   Your blog, twitter account, etc.?  It’s probably even better, unless you’re somehow paying on a cost-per-post basis.

Let’s say that an average subscriber sticks around for 10 months, and that I publish 20 issues a month.  And, while I’m making up pie-in-the-sky numbers, let’s also assume I can get $5.00 CPM from advertisers, on average, over the course of those ten months.  The lifetime value of each subscriber?   $1.  Each subscriber receives 200 emails, and at $5 per 1000, that’s a buck.

That LTV – $1 – is my upper limit.  Spend any more to get a subscriber and I am losing money with every additional subscriber, and that’s bad news.  So while word of mouth, Tweets, Facebook posts, guest blog posts (did I mention you should subscribe to the newsletter?), etc. are all very good ideas -- that’s how I’ve made it to about 4,000 people signed up thus far -- are also pretty close to the only viable ways to grow the subscriber base.   

Other ideas?  AdWords or Facebook ads would cost about $0.25 per click to advertise on “learn something new every day,” requiring that I convert a quarter of clicks to subscriptions just to break even – a tall task for email newsletters, akin to getting 25% of visitors to subscribe to your blog’s RSS feed.  A lot of list-building (cue ominous scare quotes) “best practices” – co-registration, contests/incentivized signups, etc. – will hurt the CPM level and likely lead to a much lower LTV.   And buying lists?  No thanks.

This inability to turn money into new subscribers, customers, etc. is a huge limit on the speed and potential for growth.  Sure, things can break well and the newsletter can grow by itself, via the methods noted above.  But those methods are a mix of elbow grease, dumb luck, a solid product, and a lot more of that dumb luck stuff – the hallmarks of the “secret sauce” which somehow, some way turns a hobby into a viable business, in a manner and fashion beyond repetition.

LTV > CPA applies, of course, beyond newsletters and beyond media, digital or otherwise.  It’s generally easy to apply, as even estimations based on guesses and conjecture are enough to make sure that you’re not making a huge mistake.   After all, it may be a great idea to spend a ton of capital and spend it to grow your customer base, but not if you’re spending more money to get each additional customer than that customer is worth.

Margins (continued)

Last week in MBA Mondays we talked about margins, which I defined as:

Margin is the amount of money you make on each incremental sale or unit of revenue before factoring in the "fixed costs" of your business.

That led Amish Shah to leave me this comment:

While you focused this post on margin from "incremental sale" (gross margin), I think it's important to acknowledge that there are other margins in the business. And they shouldn't be ignored.

Operating Margin, for example, is another one I like to look at (and you have previously mentioned it is the most interesting line in a P&L). There's a lot of info in there... Salesforce's gross margin looks great at 80% but operating margin is a lot less glamorous at 0-10%, depending on which quarter you look at.

As Amish points out there are other kinds of margins in a business. I like to focus on "gross margin" because I think it tells you a lot about the scalability of a business (as I detailed in last week's post). But operating margin which is gross margin less all the operating costs is another really important metric.

There are relatively low gross margin business (like Apple which has gross margings of 38.5%) which have relatively high operating margins (Apple has operating margins of 29.2%). And as Amish points out, you can have a relatively high gross margin business like Salesforce have relatively low operating margins.

It is important to pay attention to these metrics. You might have two businesses with identical operating margins but one has high gross margins and high operating costs (like Salesforce) and the other has low gross margins and low operating costs (like Apple). The businesses will be very different to manage and will require different teams, strategies, and financing requirements.

Margins

Margin or margins is a word you hear a lot in business. I want to talk about what it means and why it is important today on MBA Mondays. I did talk about margins once before, in the context of the income statement, back when we were walking through the basic financial statements. But I'd like to talk about the concept outside a strict accounting definition.

Margin is the amount of money you make on each incremental sale or unit of revenue before factoring in the "fixed costs" of your business. Fixed costs would be things like the rent on your office, your administrative team, and the people who do your accounting/bookeeping work for you. The key concept to wrap your head around is some costs rise and fall based on how much revenue you have and some costs are fixed and are the "cost of keeping the doors open."

I have a friend who runs a pickles business called Ricks Picks. His pickles are awesome, but I digress. If you buy a jar of Hotties (spicy sriracha-habanero pickles) from Rick, you'll pay $7.99. That jar of pickles costs him between $4 and $5 to make and send to you. That includes buying local cucumbers from farmers, making the spicy brine, and cooking up the pickles in their industrial kitchen. That includes shipping the pickles to Rick's warehouse and then shipping them to you. Let's say all of that costs $4.50 per jar, then Rick's profit on your pickle purchase is $3.49 per jar. Margin is often expressed in percentage terms, so $3.49/$7.99 is a 43.7% margin.

Notice that I didn't include the cost of Rick's time, his office, the team in his office, the marketing efforts, the cost of his website, his accountants, and a bunch of other costs in that calculation. That is because he has to spend all of this kind of money no matter how many pickles he sells every year.

Now let's think about four different businesses that are well known in the tech business; Apple's iPad business, Google's search business, Amazon's retail business, and Salesforce's SAAS business. Each of these businesses has a different margin structure.

Apple has significant costs associated with manufacturing and selling each iPad. This article in the EE Times suggests that the "bill of materials" (often called the BOM) of parts that are used to make the iPad2 are $270. You can buy an iPad2 starting at $499. If you just subtract $270 from $499, you get $222 of margin on every iPad2. I'm not trying to be accurate here. Apple's margins on the iPad2 could be a lot higher or a lot lower than $222/iPad. I'm just trying to point out that when you make a hardware product, your margins will be impacted by the material costs of making a physical product. Apple's reported gross margins in its most recent quarter were 38.5%.

Amazon typically operates as a traditional retailer in their core e-commerce business. This Oxo kitchen tools set costs $99.99 at Amazon. Amazon purchases that item in bulk from Oxo (or a distributor) for something less. Maybe $60 or $70 per unit. So they have a margin of $30 or $40 per unit. Amazon is not a manufacturer. Oxo is. So Amazon's cost is the price at which the manufacturer is willing to sell it the item at wholesale. Amazon's reported gross margins in its most recent quarter were 20%.

Salesforce is a hosted software company. When you become a customer, they don't have to make anything new to service you. They just open up additional resources on one of their servers and you are good to go. They have very high fixed costs associated with building, maintaining, servicing, and selling their software, but the cost of actually delivering an additional unit of revenue is very low. Salesforce's reported gross margins in its most recent quarter were almost 80%.

Google's search business is a media business with aspects of the hosted software model. Providing search queries to consumers is a lot like salesforce's hosted software business. Each additional search query doesn't cost Google very much. They need to add more servers over time to handle more queries. The revenue those queries generate comes from the adwords paid search service. Some, but not all of that revenue comes self service. Some comes from a salesforce that goes out and sells keywords to large customers. But like the hosted software business, paid search is a high margin business. Google's reported gross margins in its most recent quarter were 65%.

Now that we've gone through a bunch of examples of businesses with different kinds of margins, let's talk about why margins matter. In general higher margin businesses are easier businesses to grow and manage. Lower margin businesses are often very difficult to scale, both operationally and financially.

If you think about my friend Rick, he has to go out and spend a lot of money every summer and fall when cucumbers, beans, beets, and okra are less expensive, higher quality, and fresh from the local farm, make and jar the pickles and move them into his warehouse. That is cash out the door. Then over the rest of the year, he sells the product, gradually getting back the money he laid out plus his margin. As his business grows, that summer/fall production runs costs more and more. And the dollar value of inventory in his warehouse grows. He has to come up with some way to pay for that production. This is called working capital and in lower margin businesses, working capital isssues loom large and are an impediment to growth.

 Let's look at a hosted software business in the mold of salesforce.com. They spend money upfront to build and host the software but then as their business scales, the cost of "manufacturing their product" is relatively low. They can grow rapidly without having to come up with huge amounts of capital to finance that growth.

When you think about your business; starting it, building it, scaling it, and financing it, pay a lot of attention to your margins. Understand what kind of business you operate and where it fits in the margin universe. Understand how those margins will impact your operations and your financing needs. There is nothing worse than waking up mid-course and realizing you have a lower margin business than you thought that is more capital intensive than you thought and you are caught without a plan to deal with these issues. I've seen that kind of thing kill more than a few companies.