Hacking the venture process

I just stumbled upon (not StumbledUpon) a site that discusses venture funding: Venture Hacks. Started by Babak Nivi and Naval Ravikant, both of whom have been on the entrepreneur and VC side of things, the site brings oodles of information for you, the entrepreneur. They present a series of articles on term-sheet-hacks.

The VCs know more than you do.

You, the entrepreneur, negotiate a term sheet once every few years. You negotiate your most important term sheet (the Series A) when you have the least experience. You negotiate against a VC firm that issues two to three term sheets per month. You negotiate against a “standard” term sheet that encapsulates decades of combined knowledge from hundreds of venture firms.

If you're a newbie to what a "term sheet" means, join the gang. You might want to read Brad Feld's term sheet series first.

Let me give you the low down: Term sheets are what VCs use to tighten hold on your private parts. If you don't negotiate, you will be left with a very painful experience. Don't let them get to you.

You probably know this, but both Venture Hacks and Feld's series are representative of VC points of view. Yes, they're both much more leaning to the entrepreneur, but you'll note a subtle VC bias in the approach, which simply means making more money for the VC at the cost of the entrepreneur. They never tell the entrepreneur to break a deal on a clause, but mention how VCs will take certain things like no-founder-vesting as a dealbreaker. Just so you know.

One thing though: these hacks assume that VCs are willing to "discuss" elements of term sheets, and that you have some reason for the VC to listen to you ("leverage"). If you find that is not the case with you, you can shut down your browser and either take what you can get or carry on without the VC world.

You might think that all of these things are applicable to India. They are, but you have to see them in the right context.

1. Convertible preference shares are "debentures" in the Indian context.

2. Very few Indian lawyers that know anything about negotation will come cheap, so if you hire a lawyer, be ready to shell out lots of Mahatma Gandhi adorned pieces of paper.

3. The legal process takes a lot of time in India, so please expect a lot more anti-entrepreneur clauses in Indian term-sheets.

4. Option pools have a serious Fringe Benefit Tax impact. If you set up an option pool based on VC term sheet, be ready to understand how this impacts your revenue guidance, since FBT is payable by the company. (Yes, you can bill it to the employee, but which employee will pay for illiquid stock?)

A better approach is to create a trust that will issue the ESOP, but the company must not own the trust. VCs will balk at this. Why?

Think about it. Let's say you get a pre-money valuation of 8 crores (for say 10 lakh shares), and VC puts in 4 crores. You think, heck this is great! 33% to VCs, rest to founders! Founders are worth 8 crores!

But they say they want a 20% option pool, created pre-money. Means, post their investment, they will have 4 cr. worth shares, option pool is another 2.4 cr. and you have the remaining - 5.6 cr. worth shares. Suddenly you're worth a lot lesser. And since the option pool is not vested yet, the real shares issued are worth 5.6 cr. (to founders) and 4 cr. (to VCs). This means they hold 42% of the company at investment.

If you went and created an option holding trust, the VCs only get 33% (since the option shares are issued to the trust). That's not in their favour - if they get a buyer they will benefit from unvested shares in the first case, but with a trust the trustees will benefit (and the founders will be the trustees). VCs will not be happy.

I hope you enjoy the sites. I did. I will write more about the Indian context to these options.

Where angels fear to tread

If you're reading my blog post by post, I will sound like a broken record about this, but bear with me please.

I'd complained about the general lack of deal flow and VC issues here, here and here. A recent post on Venturewoods had comments leading into the angel investment space. Angel investors, for the uninitiated, are those that give money to entrepreneurs when have diddly squat to demo. When people want money to build something that they can make very big, they will need to turn to angel investors.

Why? Because the typical amounts such ideas need are between 10 and 50 lakhs. Why that much? Two founders, salaries for a year @25K per month, let's say they need equipment, outsourced graphics design and programming perhaps, colocated or dedicated web space, collateral, etc. And perhaps a small team of people towards the end of the year to be able to generate the traction needed for a VC funding round. Okay maybe this is too big an amount, but everyone is not debt free and rent free.

You might think: Ok, why not go to a VC directly? VCs have $20-100 million dollar funds. They don't want to invest pocket change in you right now - after all, what you have is a dream and everyone has a dream, including Martin Luther King. For unlike him, everyone's dream cannot become reality. So they tell you to do something, hustle around, get some "traction" and come back.

Plus, if they gave you your 50 lakhs ($100K) they will need to fund some 200 companies like you in order to cover their fund of 20 million. Now if these 200 companies gave progress reports just ONCE a quarter, the VC will have to meet 3 companies a day just to cover them all in a quarter, and heaven forbid someone wants time in between. Typically VCs do 10-20 investments.

You might say: Uhm, why not find a VC that has only 5 million? I will now ask you to sit back and think about how VCs get paid. They get a "management fee" which is a percentage of the fund value, and they get a profit fee. Profits are five years away at least, so how does the VC pay their bills? Yes, management fees. Say that's 5% (I am picking a figure from the air). For a $20 million fund, fees are $1 million which pays for the lexus, the chalet and the trips to investor meetings in Honolulu. (To any VCs that are reading: I'm kidding! The Lexus is already paid for)

Now think about a piddly $5 million fund. The fees there are $250K which covers less than Bipasha Basu's clothing, speaking in the VC world. (Not that Bipasha Basu is in the VC world, though if that happened we would have a lot less bickering) That kind of VC would have to travel economy class, which means 'regular' VCs will have the room cleaned with water from the Ganga after they visit.

So VCs won't want to hear about your 10-50 lakh thingie. Now what do you do? Let's say your project manager, a smart guy with lots of contacts and good industry knowledge, professes interest in providing you the money - but he won't join you. Just be on the board, help with some initial setting up and refining, and provide the money you need to get traction, so you can go to the VC.

In return, you give him equity - say 25% of your company. He is now your angel investor.

If, after a year, you go to a VC who values your company at 18 crores ($5 million) and now is happy to invest another 9 crores. What happens to your angel investor?

In the US, many investors will pay the angel the valued amount of his stake (full or partial) and take over his stock. Your angel investor is happy to get this kind of a return and doesn't have to wait 5 more years - that was his risk taking capacity.

This kind of partial or complete cash-out happens at many levels in the US - from first round to second, and even founder partial-cash-outs . This is what I call deal-flow.

Deal-flow is non-existent in India and the reasoning for this, judging from the comments in the venturewoods post, is because VCs are not happy to see other investors exit. Why aren't they staying, they say, and is there something they don't like about this company that we are overlooking?

Plus, of course, financially it means someone is exiting when you are entering. The greater fool theory means that I will buy at a high price and find a bigger fool who I will sell to at an even higher price. VCs do not want to be the greater fool. The fact that they are buying from someone else makes them feel they could be one.

But that theory holds very little water. In mature markets like stock exchanges and such, there are people who buy high and sell higher all the time. Even traders buy high priced goods and add their margin when selling to others - and you have been a greater fool at some point in your life. Ever drunk Barista coffee? You're a greater fool. Ever eaten at a five star? You're a greater fool. Ever bought a cinema ticket in "black"? There you go. Ok these are consumption themes, but I don't know what business you are in - even so, do you take a salary from your company? You are a greater fool - it is far more worthwhile to take the same money in a consulting role. Being a greater fool suddenly is not as bad as you think.

Of course the other big issue is of valuation. Startups are founded by people who may not have too much of an idea about finance. When I started Agni, we brought in two other people who frankly provided very little to the company (though one did give us some office space to start, and later charged us the rent) - but we gave them stake at the same proportion as our money bought. Yes, really. This was 1998, and I was an uninitiated fool.

VC's will generally identify that the founders have been screwed in an angel round, and therefore readjust the capital to distribute the real value. The being-screwed part is obviously subjective, for angels will argue that they paid money where nothing was visible, so their investment would cover the risk. But then the VCs have the money, and the golden rule of finance is: Who has the gold makes the rules.

Thus VC investment generally means that angel stake gets substantially corroded, and therefore it may be in her best interest to sell the stake during the VC round - there is no management input by definition, and there is no control, and this in a private illiquid company; all reasons to sell out. Of course, all of this may be overshadowed by the phenomenal growth potential, and most angels would stay invested. Yet, some may decide they would like to exit, and providing them that exit path is best for all in question - the VC, the founder and of course, the angel herself.

The one way to avoid this is to find angel investors willing to stay very long term. Not that tough, even project managers will have that tenacity. And the second way is to use bridge loans.

At seed time, valuations are murky, so there's no end to valuation arguments. Therefore seed investors can provide capital as a loan, convertible to equity at two points - a) if the company is acquired and b) if there is VC investment. In either case, the conversion will happen at a discount to the valuation offered; say 30% or such. Such loans will be given at about 5% above the market rates, and the accrued interest is not paid out, instead it adds on to the loan amount for a later conversion. This is called a bridge loan (or at least, that's what I call it)

This is great stuff - in fact if you are starting a company, and investing your own money, go down this route. Reason it's great is - if you buy shares early, then you end up valuing the company way too low, which obviously affects other investors later. Secondly, you keep the cash as a loan so if the company goes down you will have first claim on any assets. Convertible debt as a bridge loan is what even big companies do now, through convertible debentures, FCCBs and such. In fact, if VCs were not afraid of losing control, they would also use convertible debt as an option.

Angels can therefore provide money as a bridge loan instead. This kind of thing is just starting to happen, and it may now be the evolution of the angel process. Yet, angels will want to see the possibility of earlier exits if the angel space is to really evolve.

And why should the angel space evolve? Because when you start, you don't need $2-3 million. With tech becoming cheaper and cheaper, why would you take that much money when you can do with far lesser? But VCs won't give you lesser, and angels aren't even in there because the model doesn't permit exits easily. Perhaps we should change the model.

As for founders - I would say put your money as a bridge loan, and take stock options for your hard work. So part of your stake will come as conversion of your upfront money and another part as options vested over time. That arrangement comforts a later VC also about valuation.

Thoughts?

Startup hiccups in India

Dharmesh Shah analyses why there aren't more software startups in India. By "Startup", he means a company that produces a product - not the BPOs, or the software service companies. He means software product companies, of the likes of Tally Solutions, Picsquare and the new startup that I will be starting in a few days but haven't had the time to build the darn home page yet.

Now yours truly is going to counter-analyse and put in points from a) someone who started a company at age 23 and b) someone who is going to start once more at 32, but this time on a completely different front.

Service companies have lower risk
Startup or service company? When you look at it from an entrepreneur point of view, it's about food on the today (service company) or a gourmet meal far far away in the distance. Dharmesh says the risk of a software service company is lower; and I agree.

I will digress right now into a brief history of my first startup; we went down the "service company" route, though initially only as a funding source.

When I started Agni, I was 23, it was 1998, I had unending reserves of energy and was totally clueless. Which are the prime requirements for starting a company with nearly nothing in your pocket. We put in Rs. 30,000 each - four of us - which was all the money I owned at the time. All of us also brought in our home computers, and set it up in a first floor room of a company owned by a company that was ok with renting it to us without a deposit.

Chirag and I - two of the four founders - had no rent to pay or other big liabilities so we decided that we would go full time into the business, and Arun and Bhaskar, the other two, decided they will get themselves a day job. The deal was: Within three months we generate cash flow to pay us Rs. 15,000 every month, and we all go full time. Otherwise, we shut shop and go away.

We started as "corporate trainers" - meaning we would go to big companies and do five day training courses on C++, Delphi, Java and the like. Even the day jobbers took part - and in three months we generated the required cash flow, everyone went in full time etc. All a happy story till now.

Enter the product. Fin-Acc, an accounting software that would beat the pants off the competition. Two founders would develop it full time - but how to pay their salaries?

(Note: We hadn't even started to think of marketing costs - we were conveniently using Chinese math like 100,000 companies register every month, and where will they get their accounting packages, we can easily get 1% of this market and so on. Our eyes were the shape of dollar signs - because the rupee sign simply does not make for good eyeball graphics - and we honestly believed that if we built it, they would come, hand over their money in small bills in paper bags, and beg us to give them our product. I love those times.)

So, to finance this, there would be a "services division", which was the remaining two founders looking for service contracts worldwide. Luckily we got a break in Europe and then in the US and the "services division" became stronger.

Eventually, as the product started to take away more money than we could throw at it, we began to pull the rug. Take out the newspaper ads. Pull down the hoardings. No more stalls at IT.COM. And later, ditch the product idea - let's sell the service of getting companies accounts online.

What am I getting at? We were forced to go down the service route initially because we had no money. Later, we did it because the product was just not getting COMPARABLE revenues to the services division. Services is easy. Products are tough. Period.

Lack of precedence: Dharmesh says that the Indian story lacks the inspiration provided by prior startups, like in the US you have the Intels and the Microsofts. In India, whaddya got? Infosys, which landed a big contract in 1990 and became a services giant. TCS and Wipro, which was funded by an established house. And while these guys have some product lines, they are primarily service businesses.

But I think India has good stories, albeit not always in the tech space. Suzlon Energy, Bharti Airtel and Rediff have grown from fairly humble beginnings. The recent IPO of Naukri.com has brought a new angle to tech IPOs - that a web company can get an huge valuation in the Indian stock markets.

But yes, the garage companies have still not set a precedent. There aren't that many IPOs - I don't know why, in the face of growing investor awareness, large fund investments and lower regulatory problems - but I'm sure that equation will change. After all, I'm not the only soul that realises even a sub 100 crore turnover is enough to take a company public.

Early stage capital is hard to find: I've talked about it in the context of "not enough capital" and "no more VCs?" earlier. Deal flow is not acceptable and angel investors are either not there or are more chip-on-shoulder than VCs. Okay, gross generalisation.

Bureaucracy: Dharmesh says:

Here in the U.S., I can have a brilliant idea for a software startup and within about 72 hours have launched a “real” company. By “real”, I mean it will be registered (LLC or S-Corp), have a Federal Tax ID, have a merchant account to accept payments, a bank account and a small business credit card. I’m not sure how long the equivalent process takes in India, but I’m guessing at least weeks.

This may not be such a huge hurdle anymore, as even Dharmesh admits in the comments. But let me see:

- Starting a company: If you start a private limited company, this requires a Director Identification Number (costs Rs. 2000 or so and can take a while to get), a copy of a PAN card and such. You also need some "Memorandum and Articles of Association" and application documents which your accountant will snag from another similar company. You will then need to apply for the name of the company, which requires government approval. Okay, it's a pain in the ass. But if you choose to start a partnership firm, which makes sense because you're not going into debt, it's a 10 minute job.

- Getting a Tax ID for a company is an over the counter thing nowadays, and a bank account takes from 1 day to 7 days.

- Merchant Account: You can get one easily at CCAvenue. If you want to be an offline merchant, i.e. get a swiping machine and stuff, it will cost you more time and money. And you have to convince the bank you're not going to cheat customers. Such is life.

- Getting a small business credit card: You can probably forget about this one. Businesses don't get credit that easy, and all you can do is get a personal credit card.

- Dharmesh mentions that it requires a more gregarious attitude to get things done in India. Well, I don't know; I'm not an introverted shy sort of person, I'm more of the sort Dharmesh describes that will "get things done". You probably have to find such a person, but I've found that accountants and social circles help.

All in all, bureaucracy is a pain only if you want it to be. To me, it's the cost of doing business. I would love it to go away - and it's slowly easing up - but it doesn't stop me from doing what I want.

A small digression: One of the reasons I've never wanted to take up a job in the U.S. is because they grudge work permit holders the freedom to start a business. With an H1-B, you never get that freedom until you land a green card; and that process can take around 6 years. I'm ok with waiting a month for my company's tax id, but six years, man that's tough.

Recruiting employees is a challenge: This is the big one, mate. There are two aspects to this:
1) Finding people with the "drive": A tech startup needs people who are extremely passionate about what they do. So if you're going to write mobile games, you have to find people who will breathe games and understand mobile technology as if the acronyms were built into their chromosomes. There are about 10 such people, and the big companies have hired goons to protect them from you.

Okay, I'm exaggerating. But it will sure seem that way to you after a 100 interviews, 200 phone conversations, one-on-one meetings in coffee shops etc. You know what ticks me off? The kind of person that proudly puts "COM and OLE" on his resume, and when asked about how IDispatch interfaces work with late binding, will say "I don't know, we didn't touch that part in our project".

The very excuse that their "project" did not involve a certain area of a technology seems to absolve them from the need to ever learn it. This kind of person can never work in a startup. And yet, such persons are 95% of your candidates.

2) Ability to hire them: Now let's say you hit a gold mine and found a few potential hires. Convincing them to join is ultra-tough, like Dharmesh says, in the face of big corporate salaries, perks, and importantly the cultural peace you get by working with a "known brand". I'm one of those guys who doesn't give a rats ass about my "career growth", but the Indian recruit-o-sphere is littered with those that want a shiny, polished, smooth-upward-curve resume, in which your startup obviously causes undesirable bumps. So you can't hire the career types, the money types or the known brand types. Now you are left with a sum total of two people you can hire, one of whom is you.

It's also interesting that Dharmesh mentions the marriage angle; that startups are not considered kosher for the marriage market. One of my friends, who was a consultant making obscene amounts of money working only six months a year, had to join a big name company when his in-laws postulated that the lack of a fixed job was not explainable to their relatives. Think about it. His wife and his in-laws were ok with his job, and the money was great, but he got a job so that their relatives wouldn't raise eyebrows.

He quit the job a month after his marriage.

Product companies are tough and creative: What Dharmesh says here is a little subtle; that Indians, in general, don't want to spend time on the creative nature of product development, and are more focussed on practical, heavy things. Uhmm...I think he's right here. There are some essential small parts of development - usability, clarity, no. of clicks to get something done etc. which are largely ignored by developers and companies alike.

I think it's not that we don't think of it. It's that we don't try to refine ourselves once our product is out.

A commenter also mentioned that a huge problem is lack of local market. India by itself is not so much a consumer of software products. Not only is piracy rampant, but people simply do not pay in volumes that make any sense. The lack of local market means that most startups look to get customers from abroad; it is now painfully obvious that you should be where your customers are, therefore the startup moves to other shores for selling, customer acquisition etc. and leaves India as a development/testing location. It is now no longer an Indian startup.

The lack of a local market is relative. Maybe this is not the place for a youtube or a facebook. For mobile content providers, it's *the* market. For online travel ticketing, jobs and real estate portals and the like, it's showing tremendous potential. And I believe there is a big market for discount bookstores, tax return software, fast food restaurants etc.

Overall, I think startups in India will be tough to come by. It's largely the lack of good people that will kill the enthu of the few that do start. Yet, all it will take, and I shamelessly borrow from someone whose name I don't remember, is a few good men and women.

Founder payouts are now in business

Turns out The Founders Fund has started talking openly a partial buyout of founder stock by Venture Capitalists. What this means in simple terms is: When a VC firm invests in a company, they give part of the money to the founder in exchange for her stock.

Now TFF (my acronym) is a group of founders, so you would think they are biased. They've been founders that have become VCs; and perhaps they understand the nature of entrepreneurs better. They are doing something a lot of people (including me) have been talking about lately. Paul Graham mentions this in two essays. For angels he ascribes this as a plus:

Angels have a corresponding advantage, however: they're also not bound by all the rules that VC firms are. And so they can, for example, allow founders to cash out partially in a funding round, by selling some of their stock directly to the investors.

And he says it to VCs too:

..letting the founders sell a little stock early would generally be better for the company, because it would cause the founders' attitudes toward risk to be aligned with the VCs.

What he means is that founders have all eggs in one basket. VCs on the other hand revel in diversification, and a little money to the founders balances the risk a little bit.

Imagine this: You have struggled like crazy through the early years of a startup, drunk the early morning coffee by staying awake all night, had a lump in your throat when you told an employee his salary would be a week late, and in general took your health, family and personal life for granted; you have then built your idea on the grave of everything that will matter in the long run, and shown some traction, and then pitched it to a VC who's decided that yes, it *is* ok to fund.

Now this VC demands a big piece of the pie, asks more of your time to give him a weekly report, releases the money in parts based on performance so the lump in your throat is now a physical feature rather than a temporary blip, and in general, expects a lot more than you expected when he signed up.

In return, you ask for a bit of money to make it all seem worthwhile. And give up a bit of stock for it. It's not the end of the road, but believe me, you like a road a lot more if every once in a while, you were able to see something interesting.

Investors find that disgusting and they would say 'Yeah, after all, it's our money, why should we pay them and not the company? Why do they get paid when we don't?'

But the same guys wouldn't mind the startup paying a sign-on bonus to get new blood. And they wouldn't mind having the company pay a CFO mega bucks, a big-name auditor to say "yeah, this kinda looks sorta ok",and pay lawyers to rewrite the website terms and conditions at $500 an hour. Yet, a founder payoff is miserable, somehow? (Caveat: If this happens a few days before a liquidity event, it's kinda stupid, because the event may value the company far higher than you sell stock for)

Founders don't get less hungry when they get paid. If money has taught me anything, it is that a little bit of it makes you want a lot more. Heck, why only money, it's the lure of anything. Revealing dress = more attractive than the lack of dress. It seems the VCs want you to wear burqas instead.

Deal flow in India and not enough VC in general

Typical deal flow involves a new investor buying out an existing one as part of his investment. If I'm an Angel investor in a company that gets funded by a big VC, the VC will plough a part of the money to buy some of my stock, at the same valuation.

This happens hajaar in the US, but is practically unknown in India. While in the US they are even starting to talk about investors compensating (hold your breath) founders by buying some founder stock when they invest, in India most VCs will balk at even partial exits by prior investors.

Angel funding is only possible if there is a reasonable expectation of exits. In today's market a five year hold is probably the least you can expect to some exit event: M&A or IPO. Angels may have to hold even longer, since they fund the company from seed levels. VCs usually start buying in during year 2 - so they're ok with a three-four year hold. But angels shouldn't be expected to stay in forever - or at least, not with their entire money. VCs must understand the concept of deal flow and how it compensates earlier investors; actually, it's not that they don't understand, but it's a typical financial mentality to say "oh my god, this money won't go to the company, but to make someone else a profit, I won't pay.". That, in my opinion, is being very niggardly.

It can also be a fear psychosis, thinking "Why's this guy exiting?", but the answers to that are obvious. If a VC has done the right amount of due diligence, these questions have already been answered.

And if an angel eventually has like 5% of a company, it's practically too small for any level of control, and with more VCs in, there won't be board presence or even advisory roles for her (the angel). Letting them exit is just a better way to handle things.

But we have smart VCs here now, and I'm sure the negotiation table will start getting more and more open towards deal flows and partial exits.

Without partial exits, Angels will fear to tread into this space, and without Angel funding companies won't even be able to move to the VC level or even come to the VC with an expectation large enough for the deal to make sense. I mean you can go and ask a VC for $2 million today, because that's how much you have bootstrapped a company without funding. But 2 million is too small for most VCs to think about, with the huge liquidity of today. The right angels may have made the company ask for a lot more, and an angel exit alongside means that the VC can put in their minimum quantum (part for the angels, part to the company).

Now for the "entrepreneur" end. Why don't entrepreneurs run to VCs more often?
1) Stupidity: That "small pie big share" is less exciting than "big pie small share" is just not prevalent enough, mainly because everyone wants "big pie big share". If you can pull it off, BigPieBigShare is a great place to be. But to pull it off, you need NonDebtMoney and BigTimeContacts which VCs can get for you, and that means BigPie in less time than TheSpanishInquisition. But yes, SmallerShare. Even I have been guilty of this. Yes, I have been stupid.

2) They're Timid: So many people I know just don't have the balls to stand up and say they're good enough and they deserve it and they've done this. And when you combine "timid" with "to big an ego" it's complicated - first you have someone who's too scared to say "I am good", and when he does, and someone tells him "that's crap", he gets all flustered and unhappy. What you have to be is thick-skinned and frikking confident. And for heaven's sake, don't say "we" when you mean "I".

3) Urban legends and true stories: I've only heard bad things about VCs. Why? Because only the bad stories come out. If founders say they love their VCs and how "strategic" and "compatible" and other such words the VCs are to the business, you only think: "Saala, suck up kar raha hai because he wants more money". The bad stories somehow seem more spicy; there's a book called "BooHoo" which is a cry-baby book about Boo.com's phenomenal failure after $100 million of funding. Guess who gets blamed.

4) Lack of respect: If VCs don't know your business you are bound to think about why you even bother to talk to them. It's easier to ditch them upfront, because then they will start the fishmarket haggling over silly things and piss you off. But what do you do when 90% of your VC universe is filled with prople who don't know XML from a bar of SOAP. Okay, that's changing. But it's still pretty lousy out there.

Having said that, I believe today does not have to mean tomorrow. Change is essential, and change is happening. In a few years, you will laugh reading this blog post and call it "those days".