Tech Capital Partners Blog

A few years ago, we (as a community) strategically decided that we would no longer have “pitch competition” events in Waterloo. Pitch competitions are events where a number of technology company founders/CEOs come together to “pitch” their companies to a panel of investors.

Canadian technology companies believe they might secure financing by participating in these events. The reality is, VCs don’t typically fund companies that participate in these events because the companies have already pitched (unsuccessfully) most of the VCs prior to the competition…

Rather than pitch competitions, we need events that provide support for our entrepreneurs. If we give entrepreneurs the education and tools they need to build successful companies, the money will come. We need to stop focusing on pitching and financing, and start focusing on education, networks and revenue.

There are some events in Canada that I would like to shine a spotlight on. These events are focused on entrepreneurs as opposed to VCs — which, in my opinion, is how it should be. Events like mesh, StartupEmpire and Entrepreneur Week provide opportunities for entrepreneurs to learn, build their networks, and develop strategic partnerships. I am also a huge fan of the “Camp” un-conferences (BarCamp, DemoCamp, StartupCamp, etc.) where entrepreneurs support and encourage each other.

VCs are at these events looking for entrepreneurs who are focused on building their companies. A couple of weeks ago, almost every VC firm in Canada was represented at StartupEmpire and the Founders & Funders dinner during Entrepreneur Week was packed with VCs — all of whom were working the room. Build a great company and we will be there (of course, by then, you might not need us, which is great).

By now most everyone, including yours truly, has seen the Sequoia 56 slide missive on the current state of the VC market: R.I.P Good Times

And you probably have seen:
Ron Conway: Cut expenses now
Benchmark: Conserve Capital

Whether you are funded or embarking on fundraising, these are very well argued essays on capital management that might inform your approach.

I hesitate to add the following link because of the gratuitous use of the F-bomb, so be forewarned. However, Dave McClure does add an interesting counter perspective to the discussion

Dave McClure: Fear is the Mind Killer of the Silicon Valley

I concur with the need to focus on efficient deployment of capital. However, I would argue that there is an important difference in the Canadian VC market…

We have been living in a low liquidity market for 2 to 3 years.  At this point, liquidity in the Canadian VC market is lower than I have ever seen it and the specter of the formation of new capital pools gets bleaker by the day.

Attracting capital today is a monumental task.  A build it and they will come, “Field of Dreams”, strategy based on a solid dose of hope is not the kind of plan that would attract a lot of attention.

Companies that have been funded need to recognize that subsequent rounds are not an entitlement.  In fact, it is not necessarily the case that the existing syndicate will be ready to support you.  As we have seen over recent history, when a VC fund finds it has less capital than anticipated it will triage the portfolio in an attempt to allocate cash resources to the perceived winners.  At times, VC funds can use pretty crude metrics to make these decisions which do not necessarily take into account the fact that in technology the path from A to B is never a straight line.

The immediate reaction may be to reduce burn, which of course is pretty easy to do. You might not have much of a company left after blindly cutting costs but it can be  done.  Certainly, one wants to come out of the other side with a strong position in the marketplace rather than being the company that blew its lead due to timidity.  However, slide 49 in the Sequoia presentation is a sobering diagram.

So here is the question I think we all need to be asking:

How do you balance capital conservation with business priorities?
These discussions need to be held at the management level, at the board level, and with the investors.  It is likely there won’t be general agreement so a consensus will need to be built.

Obviously, the specific tactics will differ for every situation.  However for venture backed companies good shareholder management will be a key success factor.  For this, I can offer some general suggestions:

• Be realistic:
  • Your customers will change their buying patters.  Have you included this in your analysis?
• Over communicate with your investors:
  • Nothing is more frustrating than a portfolio company that only reaches out to investors when they need money. Failing to communicate puts your investors on the defensive immediately. If your VCs are half as “value add” as they told you they would be when they invested, they should be able to provide some very good input.
• Set expectations early:
  • Don’t be unnecessarily negative, but now is the time to deliver the bad news. Lay a realistic foundation as a basis to move forward. Setting this baseline now will hopefully keep you from having to spend half of every future meeting explaining missed targets that aren’t realistic in today’s market.
• Determine the ability/appetite of your investors to continue supporting you:
  • Selling your investors on your company is a continuous process.
• And last but not least, be upfront.  And ask your investors to be upfront with you.

In my last post I discussed exits and ended by stating we tell our companies: “build the company on the assumption it will go public but recognize that a strategic sale is more likely so don’t do anything that will make a sale difficult”. So what are those things that make a sale easier in the future? While not exhaustive here is a short list:

Own all intellectual property
Any acquirer is going to want to know they are acquiring all IP rights. This means from early on you need to ensure the company owns all of its intellectual property. You need to ensure that everyone who has played a role in development has assigned their rights to the company. Specifically:

• All individuals who “touched” the IP prior to a company being formed need to have explicitly assigned the IP to the company. Even if you had friends help you brainstorm early on it is important that they sign IP transfer agreements.
• If developed in a university setting, all students will need to sign IP transfer agreements.
• Once incorporated, all employment contracts should explicitly state that the company owns all IP developed by the employees.

Standardize employment agreements
It will drive potential acquirers crazy if every employee has their own form of employment agreement. Best practice is to use one standard form of agreement for all  employees. Obviously items such as salary will change from employee to employee but the basic form of agreement should be consistent. This also makes negotiations with potential employees easier as you can simply say the form is non-negotiable.

Make option agreements comply with regulatory requirements
There is no significant cost to ensure your private company stock option plan is consistent with that of a public company so why not make it compliant from day one. This makes it easier for an acquirer as they will not likely have to take any accounting hits (stock based compensation charges) that could impact their willingness to complete a transaction.

Don’t have change of control provisions in option agreements
During the “bubble” there was a tendency for stock option plans to have a provision that provided for full vesting of options on a change in control (i.e. an acquisition). Today that is not the norm. Full vesting will scare an acquirer who will be concerned about the ability to keep the company intact after acquisition. If they do agree to proceed notwithstanding the acceleration, it will usually mean a reduced price because they will need to allocate some portion of what would have been included in the purchase price towards retention bonuses and/or new stock options to provide an incentive for employees to remain. Today’s market is such that only a handful of employees will usually have accelerated vesting – usually only the CEO and CFO as often both are not retained post acquisition.

Be consistent with customer terms and conditions
Do you have a standard set of terms and conditions that govern sales? If not, you should put a set in place immediately. While I realize early on you need to be flexible and work with customers, you want to try to be as consistent as possible. Ideally you want things like warranty periods and support hours to be consistent from customer to customer. You want to make it easy for an acquirer to get through diligence and standardized terms make it simpler.

Avoid complicated tax/business structures
At the risk of offending well meaning lawyers and other advisors, stay away from complicated corporate structures. Yes, in theory moving your IP to an offshore entity and then licensing back to Canadian and US operating entities may save you some taxes down the road but the reality is you are spending time and money up front for a benefit you will not realize until you are profitable. More importantly, you are unlikely to realize the benefit at all because you will likely be acquired before the benefits kick in. A foreign structure will make it more complicated for an acquirer who may even want the structure unwound before completing the purchase.

People often ask me about how to become a venture capitalist and how I *decided* I wanted to be a VC. I must admit, a career in venture capital was not at the top of my list as I tried to figure out what I wanted to do right out of school. Venture capital wasn’t one of the careers that was showcased on “career day” and I don’t remember my high school guidance counsellor recommending venture capital as a career choice.

Not sure this is the ideal time to be writing this post as markets are crashing all around me but nevertheless, here I am, several years out of school and seven years into my career as a VC reflecting on how I got here…

Looking around at my peers, there seem to be a couple of traditional paths people follow to become a VC. Some people get an undergraduate degree in engineering/finance and then an MBA, join an investment bank or venture capital firm at the Analyst/Associate level and then work their way up through the organization over time. Others are successful entrepreneurs who have built a number of companies before joining a venture capital firm at the Partner level. A while back, Seth Levine wrote a couple of blog posts: How to become a Venture Capitalist and How to get a job in venture capital (and the comments are just as informative as the original posts).

My journey started with passion for marketing and technology. For as long as I can remember, I’ve been interested in bringing technology products to market and building technology companies. I remember thinking in university as my peers were clamouring for marketing jobs in the consumer products industry “who would want to sell butter?” Luckily, one of my first jobs out of school was working for a technology focused marketing consulting firm and following that, working at PixStream, a technology company focused on distributing and managing digital video across broadband networks. My first exposure to venture capital was at PixStream in 1999/2000 and the experience (through the bubble) was a wild ride. Following PixStream’s acquisition by Cisco in 2000, Tim and Andrew at Tech Capital invited me to join the firm as a marketing operations resource for the firm’s portfolio companies which I did for a few years before focusing more on the transactional side of the business.

Learning about what it means to be a VC is certainly easier today than it was a few years back. Information that used to be shared through apprentice-based learning is now more accessible as VCs all over the world are sharing best practices and adding transparency to the industry. There are also courses you can take through the Venture Capital Institute (high level overview of a number of aspects of venture capital) and Harvard offers an Executive Education program Private Equity and Venture Capital (focused more on private equity but some venture capital content). I’ve heard good things about the Kauffman Fellows Program although I haven’t experienced it myself.

Venture capital is a difficult industry to break into, and from time to time the job is not very fun but working everyday with brilliant and creative people who are building exciting technology companies somehow makes it all worthwhile.

Fred Wilson recently wrote a series of posts detailing the economics of a Venture Capital Fund (Economics, Gross and Net Returns, When One Deal Returns The Fund, Allocating Follow-On Capital). In his posts, Fred discusses how VCs get paid and what levels of exits are required in order to generate acceptable returns. Fred’s series of posts got me thinking about exits and I thought I would share some of my thoughts on the topic.

In very general terms, exits usually fall under one of the following categories:

Bankruptcy
Obviously not a good result. A bankruptcy occurs when a company does not have assets available to settle its liabilities. A company can elect voluntarily to declare bankruptcy or a creditor can apply to the courts to have bankruptcy proceedings start. In either case, a third party (called “a receiver”) is hired to liquidate the assets and distribute any proceeds to the creditors.  Whether or not a VC will realize any proceeds in a bankruptcy depends on the nature of the investment and the extent to which there are other creditors. In broad terms, the receiver get their fees paid first followed by the  government for things like payroll withholdings and sales tax. Next come the secured creditors - a VC may get some proceeds here if they hold secured debt or preferred shares. Last to be paid are the common shareholders and it is very unlikely in a bankruptcy that there will be anything to distribute to this group. So in summary, not a good result for anyone.

Orderly wind-up
This is similar to a bankruptcy but in this case the decision to close the business is made while there is enough cash to settle with the creditors. The liabilities are paid out and then, like in a bankruptcy, any remaining assets are distributed to shareholders in order of priority (i.e. preferred shareholders before common shareholders).  Again, not usually a very good result for the VC or the founders.

Public Offering
This is what many founders aspire to and in fact, like many VC firms, we expect our companies to act like they will be public companies one day. The process to go public is not easy and we are big believers in making things as easy as possible from day one. For example, securities regulators and stock exchanges have rules regarding stock options and stock option plans. Why not make your plan and option grants comply with public company requirements from day one so that there is one less thing to worry about in the event you eventually take the company public?

I believe there is a misconception about how people make money on an Initial Public Offering (IPO). Lets say you are the founder of a business and own one million shares, the company goes public at a price of $30 per share. You get $30 million right? Not so easy. On paper you are “worth” $30 million but you won’t be able to liquidate those shares. On the public offering, the underwriters (the brokerage firm that sells the stock) will require that all shareholders agree not to liquidate their shares for a certain period of time (say six months). For a VC, this is not ideal but it is understood it is part of the deal. What often happens is right before the lock-up period expires, the underwriters will try to arrange a sale for any investors who want to sell to avoid having a large block of shares hit the open market. Unfortunately, management will not usually be able to participate in this share sale. The markets don’t like to see founders selling large blocks of stock as it sends the “wrong message” (i.e. why don’t the founders believe in the upside potential of the stock?). If the stock is very sought after, the underwriters may agree to allow the founders to sell a small piece of their shareholdings but the reality is that as a public company it will be very difficult to realize all of your “paper wealth”. This is the catch 22 for founders –  most aspire to be public companies but the reality is it becomes tough to actually liquidate their shares. Once the company has a track record as a public entity founders should be able to sell shares using a predetermined formula (e.g. 1% of your holdings on the 10th of each month). From a VC perspective the IPO is usually a good result as it provides liquidity.

Financial sale
The sale to a financial buyer, usually a private equity firm, is unusual for early stage technology businesses because financial purchasers are looking for companies that are cash flow positive - a rarity in the tech world :). Usually a financial acquirer will fund the purchase through a combination of debt and equity. The debt lenders will base the amount they are prepared to lend on historical results and future cash flow projections, making positive cash flow a must. I sit on the board of Q9 Networks which recently announced it has agreed to be acquired by a private equity firm. I chaired the special committee of the board that dealt with the sale. After the transaction closes I will share some more thoughts about private equity acquisitions. From a VC perspective a financial sale usually provides immediate liquidity.

Strategic sale
In our experience, this is the most likely exit for VC backed technology companies. Strategic sales occur when another company buys your company for strategic reasons. The reasons can be any of the following:

• The purchaser needs to enhance their product offering and does not have time to develop internally so buys a company that has already completed development (buy vs build).
• The purchaser wants to make sure their competitors do not have access to your products or technology.
• Your technology is so proprietary it is unlikely the purchaser would have been able to develop the solution internally.
• Your technology/product will allow the purchaser to generate significant “pull through” revenue. i.e. the purchaser believes that by combining your product with their existing product they will now have a competitive advantage that will allow them to win significant new business and/or differentiate themselves from competitors.

Assuming the acquirer is paying in cash or is publicly traded, a strategic sale is usually a very good result for the VC because we are able to liquidate our investment immediately. For founders the liquidity will vary. Sometimes an acquirer will require the founders/senior management to put their proceeds in escrow with the amounts being released over time. This escrow ensures the founders remain with the business during a transition period. In other cases, the founders are able to fully liquidate and they are retained through new employment contracts and/or equity in the acquirer.

So which of the above should you aspire to? Ultimately I think you want to make sure you have options and never be in a position where you are forced in a specific direction. The overall advice we give to our founders is: “build the company on the assumption it will go public but recognize that a strategic sale is more likely so don’t do anything that will make a sale difficult.” I will cover what this means in a future post.

In a previous post I discussed why most businesses we see should probably be bootstrapped rather than venture funded. I promised to discuss a bit more about venture backed business so here it goes:

While somewhat of a self evident statement, the main reason for seeking venture funding rather than bootstrapping is to obtain capital. The key question for venture investors is why is the capital required? It is not unusual for us to receive an e-mail or call from an entrepreneur stating they have a great idea and need some money for sales and marketing. While not always the case, usually this leads to a quick decline because most often the business is one that will never generate the type of return that makes the investment worth it.

For technology investors like Tech Capital we are usually looking to invest in companies that require the capital in order to fund research and development. So how do we determine which investment opportunities to investigate and perform diligence and which ones we will pass on immediately?

We ask entrepreneurs to send us an executive summary of the business. Initially we are simply looking for information about three things:

1. Technology
2. Market
3. Team

Many people ask us what form this should take. Does it need to be a 40 page business plan? Does it need to look pretty with lots of graphs and visuals? The short answer is: No. It can simply be three paragraphs in an e-mail, as long as it covers the following:

Technology
We want to know what specific technology you are developing and what technological differences exist compared to other solutions. It is best to be as specific as possible. A generic statement such as “we have developed a better search engine” does not really provide any information and is likely to lead to a quick dismissal.

Market
We want to understand who is likely to buy the product once developed. We want to determine if this is a huge market = good or a niche market = bad. The issue is that in order for venture investment to make sense the market needs to be significant. For niche markets see my bootstrapping post. In addition to understanding the overall market, it is helpful if you can identify any early customers who are likely to participate in beta trials.

Team
Technology and Market get you in the door, then it usually comes down to team when we make an investment decision. At this point we are not expecting a company to have a full management team in place, but we do want to know a bit about the founders and any other employees. What roles have you had in the past, how long have you known each other, how long have you worked together etc. Ultimately a venture capital investment starts a partnership, so we want to know as much about our potential partners as possible. It is a bit of a cliché but we are looking to invest in people “who know what they don’t know”.  Founders who know their weaknesses and are prepared to “share the wealth” to fill in the gaps are the folks we love to partner with.

As I mentioned above, people often spend days or weeks pulling together a full business plan before we have even indicated if we want to pursue diligence. While this may have some benefit for you in the long-term the truth is we are not likely to read the full plan up front, rather we will look for the three items above in the executive summary.

The same applies to financial models. We get sent some massive spreadsheets and while we appreciate the hours (or days) that went into detailing the information, it is not something we need to evaluate an opportunity. The reality is, that with the experience we have, we can usually ballpark the financing requirements with a few simple questions. Eg Q - how many people do you plan to hire. A – 10 FTE. Q - How long do you think it will take to get to Beta. A – 12 months. Assuming you hit your plan, we know you will need approximately $1.25 million, so allowing for slippage and capital to fund the period between beta and next fundraising round we will probably assume this will be a $2 million initial investment.

Our goal is to make it easy for people to send us their opportunity so we can quickly let them know if we are interested.

I was approaching the end of my academic career at engineering school on Black Monday (October 16, 1987), a single day when the global stock market was hit by massive selling, resulting in the instantaneous evaporation of trillions of dollars of wealth). Not surprisingly, as I attempted to enter the work force in its aftermath, on-campus recruiting was substantially diminished.

As I recall, the few jobs that were being offered were for technical sales reps. The idea of a job in sales caused in me a severe allergic reaction. After all, I thought, it is a very mundane occupation, especially for someone who had just finished stuffing all the knowledge of the universe into his brain. I had no intention of wasting. Perhaps too, I had in my head a vision of Arthur Miller’s pathetic character, Willy Loman from “Death Of A Salesman” - a broken down walrus of a man who’s sense of integrity was continually compromised by his addiction to hyperbole.  That wasn’t me.  No, I was going to use my brain!

Half a lifetime later, I have revised my view on this and many other topics. I am much more circumspect about how much knowledge was ever actually between my ears and I am becoming alarmed about the rate at which whatever was in there is disappearing. Second, I am re-thinking Willy Loman. Today I see a man who admittedly has personal character flaws but has the core redeeming qualities of courage, dedication, and the self confidence to withstand rejection.

“…he takes his valises out of the car and puts them back and takes them out and puts them back again and he’s exhausted…He drives seven hundred miles and when he gets there no one knows him any more, no one welcomes him…And you tell me he has no character?”
Linda, (wife of Loman)

Maybe my changing viewpoint came from watching my wife travel from strip mall to strip mall in the whipping winter wind in Mississauga selling photocopiers and the like…facing the elements, strangers, and her heavy pitch book with joy. Maybe it was watching my father-in-law whose company would increase his quota and decrease his territory every year, and every year he would answer the bell. Maybe it was simply that I realized how hard it was when circumstances forced me to do it myself.

Ten years ago this month, I left my nice comfortable paycheck because Tim Jackson and I were going to strike out on our own. A few weeks into the adventure, I realized that if I didn’t sell I wouldn’t be able to feed my family. The product I had to sell was an investment in a venture capital fund. That might not be what we usually think of as a product but I had to sell none the less. I was scared. Could I keep going? Could I take my “valises out of the car and put them back and take them out again”? Could I handle rejection? What would I do if no one welcomed me?

During this time of epiphany, I learned that selling is a skill. There are some who are naturally gifted. I had to work hard to gain the fundamentals. But practice is rewarded and what is difficult at first, gets easier with time. There are many styles of selling, many of which are effective. Since I needed to be comfortable in my own skin I wanted to find a style that matched my temperament.

My current view is that everyone needs to know how to sell because everyone has to sell something. The engineer on the internal design team needs to sell his ideas just as the sales rep needs to sell the company’s product. When a company approaches the venture capital community, they are selling their business plan and eventually their shares. If you have aspirations of being a founder or president you need to be the best sales person in the organization. Finally, if you can ring the cash register, you will never be out of a job.

If I have convinced you to start your journey, there are many great resources. A personal favorite is How to Become a Rainmaker by Jeffery Fox, but here are a few others:

• Jeffrey Gitomer books on Sales Techniques, Training, and Motivation
• Sandler Sales Institute
• SPIN Selling
• and in many cases a simple Google search can yield some great info

“Willy was a salesman. And for a salesman, there is no rock bottom to life. He don’t put a bolt to a nut, he don’t tell you the law or give you medicine. He’s a man way out there in the blue, riding on a smile and a shoeshine. And when they start not smiling back—that’s an earthquake…A salesman is got to dream boy.  It comes with the territory.”
Uncle Charley (brother of Loman)

“So you are looking for the next RIM are you?” is the most frequent question I get when I tell people what I do. My response is usually some flip comment like “Wouldn’t that be nice!” because I suspect the inquirer doesn’t really want to hear what I think. So the conversation moves on to kids, the weather and how bad the Leafs are. But blogs are what they are and here is what I think.

What RIM has been able to accomplish in its 20+ years of existence is truly stunning. It is clear that RIM has changed the basis of competition for wireless mobile devices and applications. In a fiercely competitive landscape they have managed to outdistance their rivals through outstanding technological leadership. On the ground here in Waterloo, RIM continues to set the standard of global excellence to which all tech companies should be aspiring.

They have been able to affect the English slang lexicon by creating nouns such as  “crackberry” and verbs such as “to berry.” They have provided grown-ups with a socially acceptable security blanket… Face it, you too have “quickly checked your emails” at an awkward moment during a networking event when you had no one to talk to. Then there is the marital friction. A friend was told by his wife that he had to put the thing away for their Florida vacation. Imagine the discussion that ensued when he was caught sneaking into the bathroom for a quick peek!

So are we looking for the next RIM?

Of course we are. But what is it that makes the “next RIM” anyway?

Many years ago I worked for a big accounting firm in Toronto. Fax machines were just  reaching rapid deployment. After making that big investment, the partners were faced with the most vexing of dilemmas. Should they spend the money to roll out voicemail or should they invest in email? Acquiring both, indeed needing both, was simply out of the question.

It must have been about that time when the folks at RIM decided we would ultimately want our email on our belts. How did that happen? Why did they make that decision? Who in his or her right mind would think it was a good idea to build a consumer electronics product in Canada in a market already inhabited by corporate giants? And, this decision was made when the rest of us were still trying to decide if we needed email at all…

Vision or inspiration?

It must be that vision thing. Now that is an overused word if there ever was one. Every business plan has a vision. People go away for weekends to craft them. Shoot, you can even hire a consultant to write one for you. But if there are so many visions, why are there so few RIMs.

Thomas Edison said “Genius is one percent inspiration, ninety-nine percent perspiration.”

There is no doubt that people in the tech business work hard. Endless late nights, and weekends, trying to get the next release out. Working hard is simply a fact.

A web search of the word inspiration yields:

• arousal of the mind to special unusual activity or creativity
• a sudden intuition as part of solving a problem
• divine guidance: (theology)
• arousing to a particular emotion or action

So what do I really think? The “next RIM” won’t look like the “next RIM” when it is the “next RIM.” But when we see true inspiration, will we have the perspicacity to recognize it? That is what I think about.

One of the biggest issues we have to deal with as venture capitalists is saying “no” to a lot of people. At Tech Capital Partners we fund about 1% of the opportunities we see. That means we are saying “no” almost all of the time.

The challenge is to do this without discouraging entrepreneurs. VCs say no for a variety of reasons but in our case the biggest reason is that the company is simply not appropriate for venture capital. Most of the opportunities we see don’t require millions of dollars in capital but rather should be grown and built organically.

In these cases we encourage the entrepreneur to stop spending time fund raising and - to steal a tag line from Nike - just do it. Go get that first customer, leverage it and build a nice business. In some cases that is easier said than done but fortunately in Waterloo Region there are numerous resources available to assist.

We encourage all entrepreneurs to join Communitech. For a nominal fee you will have access to educational programs, networking opportunities, peer to peer networks, mentoring by executives in residence and access to events for entrepreneurs.

The Accelerator Centre offers programming and resources for both resident and non-resident clients. Mentoring, education programs and events run by the Accelerator Centre provide entrepreneurs with resources not available in other communities.

Other great events and resources within Waterloo Region are WatStart, BarCamp, Entrepreneur Week, CBET, and StartupCamp. Outside of Waterloo Region the list grows quickly but some notable ones are: Founders & Funders, mesh, OCE, IRAP, MaRS, OCRI, and Toronto Tech Week.

Obviously there are companies that can’t be built organically and are appropriate for venture capital - I will deal with these differences in characteristics in my next post.