More thoughts on some of Fred’s and Brad’s points about VC deal algebra, valuation, and liquidation preferences for venture-funded startups. My apologies if this gets a little too technical or too long!

On liquidation preference: Preferred stock makes sense, participating preferred makes less sense. Sure, a VC who puts capital at risk in a startup should be entitled to get his or her money out before management and common shareholders who are paid to run the business. But I’ve always had an issue (even when I was in the venture business, although admittedly not as a partner) with the participating preferred security which allows VCs to get their money out first, and then still receive their proportional share of the rest. Fred calls this “a loan with an option,” and that’s the best presentation I’ve ever heard of the security. But what’s always struck me as a bit over the top about this is that it gives VCs downside protection at the same time they’re negotiating even more upside in a deal.

One simple solution to this, if you can negotiate it, is a “kickout” provision which makes the participation feature on the security go away if the company becomes worth a multiple (usually 2x or 3x) of the post-money valuation of the financing. In other words, it gives the VC the downside protection they want but gives you and other shareholders more of the upside if things go really, really well.

On valuation and deal algebra: I completely agree that valuation is a derived number and that it’s completely misunderstood in early stage investing. However, I think that while there may be low correlation between valuation and what the business is worth today, there are a few things that have always bugged me about VC valuations:

While I understand that valuation is more a function of future potential than current value, it sometimes feels like companies get punished for having a track record. Let me clear about my point – it’s not that that I actually think VCs lower valuations unfairly when companies demonstrate poor results. It’s actually the opposite. VCs are quick to bid up the valuation on companies that don’t have revenue or even a lot of operations just because the idea is cool or because the theoretical market is large (Friendster, anyone?). I don’t think VCs as a group do a good enough job of risk-adjusting or future-competition-adjusting valuations for new companies, or they get caught up in what Fred once called Venture Fratricide and just pour money into new sectors en masse. This has the unintended side effect of making management teams of existing companies feel like their ideas aren’t interesting any more because they’re not new and shiny.

Second, it’s interesting to note that while VCs use valuation as a way of placing limits and getting protection on their bet about the future potential of the company and entrepreneur, entrepreneurs have no corresponding mechanism to place limits or receive protection against having a bad VC. (VCs actually have many tools at their disposal to reign in poorly performing management teams once the deal is signed – they can fire them, cram them down, force all their common stock to be on a vesting schedule or subject to clawback.) But make no mistake about it – a bad VC can almost kill a company, or certainly keep it from realizing its full potential, and once that deal is signed, the entrepreneur typically has little recourse. I’m not sure there’s an easy solution to this particular problem either, but it’s one that’s worth thinking through with a good lawyer the next time you negotiate a term sheet with a new venture investor (and certainly one that is easier to negotiate if you either have a good track record as an entrepreneur or multiple VCs interested in your company). I made one suggestion around participation in future financings in my earlier posting on term sheet negotiations — item #8.

The final thing that’s bugged me about valuations stems from what Fred calls the 1/3 rule (1/3 of a VC’s investments work out well, 1/3 go sideways, 1/3 go bad). As a result of the rule, valuations and deal structures can end up being about VCs getting as much upside as possible out of their winning deals to cover their losses from their zero-return deals. What bugs me about this is that entrepreneurs don’t have that same luxury of a diversified portfolio – they are 100% invested in terms of their human capital and often their investment capital in their company. I fully realize that this is the nature of the beast, but I’ve always felt as a result that entrepreneurs should negotiate – and VCs should be willing to give – proportionally much more upside to management in the event that the deal turns out to be a big winner. This point relates back to my first point about participating preferred securities.

Next up in this series…Reverse Engineering Venture Economics, and managing other kinds of investors (Angel and Strategic).

This is another in a series of postings that relate to Fred’s and Brad’s various postings about venture capital funding. (Please note I have added an 11th item in response to a comment by Jack Sinclair, Return Path’s VP of Finance and my partner in crime on all transactions for the past five years.)

I think the most important part of the venture financing process is negotiating the term sheet. Although they’re only 2-3 pages long, term sheets contain summaries of all the critical aspects of a financing, and once they’re signed, the remainder of the financing process is significantly more “automatic.” Based on the financings I’ve seen and worked on – both as a VC and as an entrepreneur – my Top 10 (now 11) biggest takeaways for entrepreneurs are as follows (not in any particular order):

1. Get a good lawyer. I mean a really good one. Not just one who you are comfortable with and who is productive and doesn’t charge you too much (as Brad says, your wife’s brother’s friend’s neighbor), but one who knows venture financings like the back of his or her hand. They’re out there, many of them have worked on both sides of these transactions – for VCs and for entrepreneurs, and they can save your ass. No matter how many deals you’ve worked on, your lawyer has worked on more of them. Return Path’s lawyer, David Albin from Finn Dixon & Herling, is great if you need one.

2. Focus on terms that matter, otherwise known as Pick your battles. A typical VC term sheet will have at least 20 terms spelled out in it. There are only a few that really matter in the end, although you should at least make sure your lawyer is comfortable that the others are reasonable and somewhat standard. Spend time on valuation, the type of security, the option pool, Board composition, and your own compensation and rights.

2a (new). Sacrifice valuation for a clean security. Everyone always thinks that price/valuation is the most important thing to maximize in a deal. However, the structure of the security can be much more important in the long run. Whether the VCs buy 33% of your company or 30% of your company is much less important than having a capital structure that’s easy for an outsider to understand and want to join (e.g., investment banker or later-stage VC).

3. Always have a BATNA (Best Alternative to a Negotiated Agreement – a fancy way of saying Plan B). This is probably the most important piece of advice I can offer, and it extends to any negotiation, not just term sheets. If you have two or three VCs who are interested in funding you, I can guarantee you will end up with better terms from the highest quality investor in the group if you play the negotiation well. If you have one term sheet, you have zero leverage in your negotiation. Yes, you will spend 2-3x the amount of time on the process, but it’s well worth it.

4. Be prepared to pay up for high quality investors. There is a world of difference between good VCs and bad VCs (both the individual partners and the firms) that will ultimately have a lot to do with how successful your company can become. The quality of your VC isn’t more important than the quality of your product or your team, but it’s right up there. But – and this is an important but – you should expect to “pay” for quality in the form of slightly weaker terms (whether valuation or type of security). This is where having a BATNA really comes in handy.

5. Ask for references. Don’t be shy – prospective VCs are checking up on you…you have every right to do the same with them. Ask them for references of CEOs they’ve worked with. Ask them for a CEO they’ve had to fire as a reference. The good ones will give you the full roster of everyone they’ve ever funded and tell you to call anyone. The bad ones will give you two names and ask for time to prep them ahead of time.

6. Don’t let the VC get away with negotiating a point by saying “we always do it this way.” That’s just not true. VCs may have a preferred way of doing deals or handling a specific term, but every deal they’ve ever done is different, and they know it. If there’s a compelling reason for them to insist on a particular term, you have the right to hear it (if it’s important to you).

7. If you have multiple investors in the syndicate, insist on a single investor counsel and a lead investor. This is essential to (a) protect your sanity, and (b) prevent you from paying zillions of dollars in legal fees. You have to make the VCs stick to it, though – they can’t come back and re-trade the deal after it’s been negotiated. This is also helpful in getting a syndicate cooperating with each other and aligning the members’ interests, particularly if it has investors who have participated in different rounds of the company’s financing. Do expect to play moderator constantly throughout the process, however, to ensure that it goes smoothly.

8. Try do deal in advance with follow-on financings. When an investor doesn’t participate in a follow-on financing, it creates a total nightmare for you. Other investors will want to punish their wayward colleague and can create massive collateral damage in the process to common shareholders and management. Just as VCs will insist on something called “pre-emptive rights” (the right to invest in future financings if they want), you and your lawyer should insist on some protection in the event that one of your investors abandons you when you are raising more capital.

9. Handle the term sheet negotiation carefully. Whether it’s an initial round or a follow-on round, how you handle yourself in this negotiation sets the tone for the next stage of your relationship with the VC. The financing is the line of demarcation between you and the VC courting each other, and the VC joining your board and effectively becoming your boss.

10. Finally don’t forget to say thank you at the end of the process. Whether you send a formal email, a handwritten note, or a token gift, be sure to thank your VCs after a financing. They’re putting their butt on the line for your company, they’re investing in YOU, and they’re making it possible for you to pursue your dream. That deserves a thoughtful thanks in my book.

Sorry for the long posting. The next one or ones in this series will be on valuation, preferences, and “Venture Capital deal algebra.”

There was a great essay in the New York Times yesterday about multitasking. The gist of the article is that multitasking, when taken to an extreme, is unproductive at best and in the case of driving, quite dangerous.

I’ve long believed that in business, as in any activity relying in part on interpersonal relationships, it’s important to be fully present when talking to other people. This is especially true in one-on-one conversations, but true even in larger meetings. The article talks about the clicking you hear when you’re talking to someone on the phone and he or she is typing in the background. And we’ve all been in meetings where someone picks up a Blackberry to reply to a presumably non-urgent email. How annoying! Better to step out of the meeting if the email is that important…or tell the person who called you that you don’t have time to talk now.

Even forgetting the annoying part, how can you possibly connect with another person when you’re reading or writing at the same time? How can you make a point or read their body language? How can you convey to the rest of the room that you’re taking the subject seriously?

Like most of us these days, I too am addicted to multitasking, repsonding to emails, answering cell phones, and the like. The only way I’ve been able to make sure I focus on the meeting at hand is to turn off the phone, leave the Blackberry or laptop in another room, bring nothing other than a piece of paper and pen to the meeting. Sure, I have to go back and enter a couple things on my computer in my to-do list afterwards instead of in real time, but it’s a worthwhile tradeoff. If I’m on the phone, I turn away from my desk or put my headset on and walk around the office to remove other temptations.

I don’t think all multitasking is bad…in fact there are lots of times where it makes great sense and is productive. But the principle of Anything Worth Doing is Worth Doing Well applies here in spades — having a conversation with another person, or being fully present and accounted for in a meeting, are usually worth doing well!

Go Ahead…Make My Day

I’ve taken to smiling and giving a simple wave to fellow joggers out in Hudson River Park on Manhattan’s lower west side, especially at off times like early mornings and late nights.  Call it the fellowship of the urban exerciser, blame it on the endorphines, whatever.  I’ve also noticed that very few people respond, even when they clearly notice.  So I tried a little experiment this morning and kept a running count (yes, pun intended).

Of the roughly 30 people I passed this morning, I’d say 15 made no acknowledgment whatsoever of my friendliness, although they clearly noticed it.  Another 7 gave me a weird look like I was nuts (perhaps not wholly incorrect).  5 were "in the zone" and legitimately didn’t notice.  A mere 2 smiled or waved back.  But the best was the very last person I passed towards the end of my run, who I ended up standing next to for a minute while I was stretching/cooling down.

Her comment:  "It’s so nice to know that there are some people who are friendly to strangers here in New York.  Thanks for making my day."  Go ahead — be 10% more friendly or smiley today.  See what effect it has on people around you.  Make someone’s day!

My dad, one of the smartest people I know, asked me a good question last week. “How’s the blog working out so far?”

My answer was generally “I’m not sure,” but as I thought about it more, I saw “good” coming from four different categories, in order of importance to me:

Thinking: One of the best things publishing a blog has done has been to force me to spend a few minutes here and there thinking about issues I encounter in a more structured way and crystallizing my point of view on them. Invaluable, but mostly for me.

Employees: A number of my employees read it, although I’m not exactly sure who since RSS is anonymous. I know this is helpful in that some of the folks in the company who I don’t speak with every day can hear more directly some of the things I’m thinking about instead of getting a filtered view from normal communication channels.

Technology: One of the main reasons I started the blog was to get more experience with blog/alert/publishing/RSS tools as I try to learn more about new technologies related to my company. This has paid off for me well so far (the technology has a long way to go!).

Business development: I have met two or three other companies who may be potential partners for Return Path through this. I also believe that the postings on industry-related topics have been helpful for both business development and PR purposes.

I promised my Dad I’d do a posting on this sometime soon…so happy Father’s Day, Pops! (I also got him a real present, don’t worry.)

Yesterday’s announcement that Microsoft is going to merge its nascent Caller ID for Email authentication standard with the more populist Sender Policy Framework (SPF) is an interesting development in the war on spam.

But what does it really mean?

It means that sender authentication is headed towards a standard. Where once there were three, now there are two (Yahoo Domain Keys is another standard, although it’s still a little unclear whether it’s competitive or complementary).

Authentication is an important component of the war on spam because it allows ISPs and other email receiveing servers to verify that the sender of the email is who he says he is. Spammers don’t do that.

But authentication is only one facet to the war on spam. The others, at least the way we see them at Return Path, are (in no particular order):

Reputation: Proving you, as a mailer, are a good guy. Low complaints, good email capture policies, working unsubscribe, proper server configuration, and a host of other components.

Monitoring: Understanding how your mailings fare in the real world. Are you being blocked? Filtered? Blacklisted? Greylisted? When? Where? By whom? And most important, why?

Best Practices: Making sure you’re doing things the right way as an emailer, attacking the root causes of complaints and blocking, creating email programs that not only work economically, but work socially as well.

Payment: Ultimately, although I’m not sure what form it will take, someone will have to eliminate the economic free ride problem that created spam in the first place. Translation: mailers will probably have to pay something, to someone, to guarantee delivery.

You Have to Throw a Stone to Get the Pond to Ripple

This is a post about productive disruption.  The title comes from one of my favorite lines from a song by Squeeze, Slap & Tickle.  But the concept is an important one for leaders at all levels, especially as businesses mature.

Founders and CEOs of early stage companies don’t disrupt the flow of the business.  Most of the time, they ARE the flow of the business.  They dominate the way everything works by definition — product development, major prospect calls, client dialog, strategy, and changes in strategy.  But as businesses get out of the startup phase and into the “growth” phase (I’m still trying to figure out what to call the phase Return Path is in right now), the founders and CEO should become less dominant.  The best way to scale a business is by not being Command Central any longer – to build an organization capable of running without you in many cases.

Organizations that get larger seek stability, and to some extent, they thrive on it.  The kinds of people you hire into a larger company aren’t accustomed to or prepared for the radical swings you get in startups.  And the business itself has needs specifically around a lack of change.  Core systems have to work flawlessly.  Changes to those systems have to go off without a hitch.  Clients need to be served and prospects need to be sold on existing products.  The world needs to understand your company’s positioning and value proposition clearly — and that can’t be the case if it’s changing all of the time.  Of course innovation is required, both within the core and outside of it, but the tensions there can be balanced out with the strengths of having a stable and profitable core (see my colleague George Bilbrey’s guest post on OnlyOnce a couple months back for more discussion on this point).

Despite all of this required stability, I think the art of being a leader in a growth organization is knowing when and how to throw that stone and get the pond to ripple — that is, when to be not just disruptive, but productively disruptive.

If done the right way, disruption from the top can be incredibly helpful and energizing to a company.  If done the wrong way, it can be distracting and demotivating.  I’ve been in environments where the latter is true, and it’s not fun.  I think the trick is to figure out how to blaze a new trail without torching what’s in place, which means forcing yourself to exercise a lot of judgment about who you disrupt, and when, and how (specifically, how you communicate what it is you’re doing and saying — see this recent post entitled “Try It On For Size” for a series of related thoughts).

Here are a few ideas for things that I’d consider productive disruption.  We’ve done some or shades of some of them at Return Path over the years.

• Challenge everyone in the organization or everyone on your team to make a “stop doing” list, which forces people to critically evaluate all their ordinary processes and tasks and meetings and understand which ones are outdated, and therefore a waste of time
• With the knowledge and buy-in of the group head, kick off an offsite meeting for a team other than the executive team by presenting them with your vision for the company three years down the road and ask them to come back to you in a week with four ideas of how they can help achieve that vision over time
• If you see something going on in the organization that rubs you the wrong way, stop it and challenge it.  Do it politely (e.g., pull key people aside if need be), but ask why it’s going on, how it relates to the company’s mission or values as the case may be.  It’s ok to put people on the defensive periodically, as long as you’re asking them questions more than advocating your own position

I’m not saying we have it all figured out.  I have no doubt that my disruption is a major annoyance sometimes to people in the organization, and especially to people to report to me.  And I’ll try to perfect the art of being productive in my disruption.  But I won’t stop doing it — I believe it’s one of the engines of forward progress in the organization.

Book Short: Beyond 10,000 Hours

In Outliers: The Story of Success, by Malcolm Gladwell (post, buy), we are taught, among other things, that it takes 10,000 hours of practice to become an expert at something, as well as a dash of luck and timing, as opposed to huge amounts of innate and unique talent.  In Talent is Overrated, by Geoff Colvin, this theory comes to life, with a very clear differentiating point – it’s not just logging the 10,000 hours, it’s HOW the hours are spent.

Colvin’s main point is that the hours need to be spent in what he calls “deliberate practice.”  The elements of deliberate practice are best explained with his example of Jerry Rice, although you can apply these to any discipline:

• He spent very little time playing football (e.g., most of his practice was building specific skills, not playing the game)
• He designed his practice to work on specific needs
• While supported by others, he did much of the work on his own (e.g., it can be repeated a lot, and there are built-in feedback loops)
• It wasn’t fun
• He defied the conventional limits of age

If you’re the kind of person who cares deeply about your own performance, let alone the performance of people around you, it doesn’t take long to be completely riveted by Colvin’s points.  They ring true, and his examples are great and cross a lot of disciplines (though not a ton about business in particular).  I wasn’t 50% done with the book before I had made my list of three key things that I need to Deliberately Practice.

There are some other great aspects to the book as well — including a section on Making Organizations Innovative, from creating a culture of innovation to allowing people the freedom to think, to a section on where passion and drive come from, but hopefully this post conveys the gist of it all.  Want to be a better CEO?  Or a better anything?  This is a good place to start the process.

Thanks to Greg Sands for sending me this excellent book.  I’m going to work it into my rotation for Return Path anniversary presents.

Selling a Line of Business

It’s been a couple of years since Return Path decided to focus on our deliverability business by divesting and spinning out our other legacy businesses. That link tells some of the story, and the rest is that subsequently, Authentic Response divested part of the Postmaster Direct business to Q Interactive.  Those three transactions, plus a number of experiences over the years on the buy side of similar transactions (Bonded Sender, Habeas, NetCreations), plus my learnings from talking to a number of other CEOs who have done similar things over the years, form the basis of this post.  The Authentic Response spin-out was also partially chronicled by Inc. Magazine in this article earlier this year.

It’s an important topic — as entrepreneurs build businesses, they frequently end up creating new revenue opportunities and go off on productive tangents.  Those new lines of business might or might not take off; but sometimes they can take off and still, down the road, end up being non-core to the overall mission of the company and therefore candidates for divestiture.  Even if they are good businesses, the overall enterprise might benefit from the focus or cash provided by a sale.  Look at the example of Occipital building the Red Laser app, then selling it to eBay to finance the rest of their business.

Here are some of the signs of a successful divestiture:

• Business is truly non-core or relies on starkly different competencies for success (e.g., one is B2B, the other is B2C)
• Business is growing rapidly and requires assistance to scale properly (either technology, or sales)
• Business has its own culture and operations and “a life of its own”

Conversely, here are some of the reasons why a divestitures of a business unit might stall or fail:

• Lack of a very compelling story as to why you’re selling the business unit
• Stand-alone financials of the unit are too hard for the buyer to determine with confidence
• Operations of the unit too tethered to the mothership
• There is some problem with the leadership of the unit (there is no stand-alone leader, the leader isn’t involved in the divestiture, the leader isn’t squarely behind the divestiture)
• Business performance weakens during the process

I have a couple points of advice to entrepreneurs in this situation.  The first is to clarify for yourself up front:  are you selling a true line of business, or are you selling assets?  If you are selling assets, you need to clearly define what they are, and what they aren’t, and you need to make sure all legal details (contracts, IP, etc.) are buttoned up before the process starts.

If you are selling a true line of business, beware that buyers will not be interested in doing any hard work, or if they feel like they have to do hard work, the price they pay for the business will reflect that in the form of a steep, steep discount.  The financials must be understandable and credible on a stand-alone basis.  The business must be completely separated from the core already.  The business must have its own management team, completely aligned with the decision to sell.

You also have to be extremely cognizant of the human aspects of what you’re doing.  Every culture is different, and I’m not advocating one style over another, but selling or spinning out a business is very different than selling a company.  There’s going to be a big difference in reactions, perceptions, hopes, and fears between the people in the core who are staying, and the people in the business unit that’s going.  Having a heightened awareness of those differences and factoring them into your communications plan is critical to success, as a poorly managed effort can end up harming both sides.

In terms of valuation expectations, don’t expect to get any credit for synergies.  You have to present them and sell them, and they may make the different between getting a deal done and not, but they will most likely not impact the price you get for the divestiture.

Finally, remember that buyers understand your psychology as well.  They know you’re selling the business for a reason (you need to raise cash, you’re concerned about its future performance, it’s become a distraction or has the potential to suck scarce resources out of your core, etc.).  They will completely understand the costs you carry, whether financial, opportunity, or mental, in continuing to own the business.  And they will factor that into the price they’re willing to offer.  Of course, as with all deals, the best thing you can do to maximize price is have multiple interested parties bidding on the deal!

Everyone’s a Direct Marketer, Part III

With every company as a direct marketer, and with (hopefully!) every company embracing some of the best DM principles, what does this shift mean for the way companies will be structured in the future?

First, let’s talk about the internal structure of a company.  The biggest shift going on here is that customers are becoming a more important part of all employees’ daily lives, not just those in the advertising department.  I wrote an earlier posting called Everyone’s a Marketer which applies here.  Most likely, more and more members of your organization are touching customers every day — and they need to be trained how to think like marketers.

But beyond that, companies will be constructed differently in the future as well.  While not true in some industries, there are many industries founded on the “mass” which will never be the same again.  Here are three examples of how direct marketing is infiltrating — but enhancing the opportunities of — corporate America.

– Disney’s film unit used to make movies only for theatrical release.  Today, they have an enormous volume of direct-to-video (or DVD) movies that never see the big screen but that drive huge sales numbers when marketed to Disney’s customer email database.

– Ralph Lauren used to make Polo shirts with a fixed number of configurations of shirt color and knitting color of the logo.  Now, you can go onto Polo.com and custom build a personalized shirt for someone with the right size and color combination of their college or company or favorite baseball team.

– Barry Diller used to run a studio, then he bought a TV network called the Home Shoping Network (and, I’d add, a lot of people laughed at him for doing so).  He has now turned HSN into InterActive Corp, a true convergence company that mixes content and media with commerce and direct marketing with brands like Match.com, Ticketmaster, eVite, CitySearch, and Expedia.

That’s it for this series.  All thoughts and comments are welcome.