Do More Faster

by Brad Feld

  Chapter 65

  Turn the Knife after You Stick It In

  David Cohen

  David is a cofounder and the co-CEO of Techstars.

  At Techstars, we’ve worked hard to teach entrepreneurs how to “turn the knife.” Whether you’re presenting your company to investors, partners, or customers, you should focus on the pain you address before you discuss the tremendous solution you’re bringing to the market.

  Describing the pain is usually quite natural, but many people forget to finish the job. Think of describing the pain as sticking the knife in. Your job is not done. You have to really make me feel it. You do this by twisting the knife slowly, deliberately, and repeatedly.

  SendGrid, one of the Techstars Boulder 2009 companies, did an excellent job of turning the knife. Their product improved the deliverability, scalability, accountability, and reliability of software-generated email. Sounds like a real problem, right? The following is how they turned the knife.

  “Twenty percent of legitimate emails sent by software companies to their customers will end up in spam folders.”

  Ouch.

  “A large e-commerce company determined that if just 1% of their annual email notifications aren’t delivered, it costs them 14 million dollars in lost sales.”

  Stop it!

  “This same company figured out that at least 7% of their email is ending up being marked as spam. This problem is literally costing them a hundred million dollars a year.”

  I’m begging you—show mercy!

  “This is an epidemic with a staggering financial cost. There are thousands of companies right now that can’t deliver legitimate email to their own customers.”

  You’re killing me here!

  Twisting the knife is key in getting the attention of investors and customers, but make sure you stop at some point and shift to actually talking about the solution—just before you kill them, but not much earlier. Don’t just show them the pain; make them beg for it to stop before moving on.

  SendGrid went on to turn the knife on Demo Day using some of these very statements, and ultimately went on to raise nearly $6 million in venture capital. They made the investors feel the pain, and then showed them an elegant solution. Billions of emails later, SendGrid is a real painkiller.

  David Cohen twisting the knife against a feeble opponent during the second annual Ben Casnocha Techstars Table Tennis Invitational.

  Chapter 66

  Don’t Overoptimize on Valuations

  Kirk Holland

  Kirk is a managing director at Access Venture Partners, where he has led investments in NexGen Storage (acquired by Fusion IO), Craftsy, RoundPegg, TapInfluence, and TaskEasy. He has been a Techstars mentor since 2008.

  Since I’m an early-stage investor, I’m biased, but I think it’s very important to make sure that your early investors are rewarded if your company is successful. They’re taking a huge risk in providing capital to you.

  Companies going through the Techstars program have historically had pre-money valuations after the program in the $1.5 million to $4 million range. However, these early-stage companies are not really worth millions of dollars when they finish the Techstars program and we make a deliberate point of reminding them of this. Forget what the market is. When someone invests a million dollars in a company at a very early stage they often wouldn’t be off-base asking for half or even two-thirds of your company.

  It often takes entrepreneurs a few moments of honest reflection before they realize this simple truth. Stop and think about it for a second: Someone is putting one million dollars into a startup that most likely has almost no revenue and is by definition extremely risky. Most startups fail, and in this case they’re going to be out a million bucks! What if that was your million dollars and this was somebody else’s baby?

  However, the best early-stage investors ask for somewhere between 20 and 33% of the company for that kind of money. This is because they recognize two very important facts. First, the entrepreneurs need to retain a big chunk of the company in order to stay motivated and eventually reap the rewards of their hard work over time. Second, the company is probably going to have to raise more money and it’s going to create more dilution for the entrepreneurs.

  In terms of valuation, Techstars has outliers on the high end and in those cases the companies predictably ended up limiting their options. For investors and founders to be happy, valuations must go up at a reasonable rate over time. We all hope that new investors in a future round will value the company higher because it will have demonstrated value and simply be worth more. If you raise your first round on a $10 million pre-money valuation, you’ve got a very long way to go to make it worth $15 million or $20 million for the next round. But if you raise your first round on a $2.5 million pre-money valuation, getting to $5 million in value is much more attainable. If your first round was priced too high, you can’t demonstrate that kind of growth in value, you’re not going to have happy investors, or there’s going to be a serious hit on the founder’s equity. Each of these things can end up severely limiting your options.

  Recognize the risk that your early investors are taking. They’re jumping into the trenches with you, betting on you and your team, and risking their capital and their reputation, too. By accepting a low (also known as “more than fair”) valuation, you recognize the risk that they take, and you ensure a meaningful reward when you’re successful. As a bonus, your investors are going to want to back you again because you’re a true partner who optimizes not only for yourself but for all your stakeholders.

  Not all investors are equal. A great investor who can help your company is worth much more than an unknown investor who will give you money and then disappear, or worse, torture you with inane questions. In addition to not overoptimizing on valuation, you should work hard to get the highest-quality and most capable investors into your company, even if that means trading off a somewhat lower valuation. Remember, you’ll be living with your investors for a long time—choose wisely.

  Chapter 67

  Get Help with Your Term Sheet

  Jason Mendelson

  Jason is a cofounder of Foundry Group and has over 20 years of experience in the venture capital and technology industries in a multitude of investing, founding, operational, and engineering roles. He was a cofounder of SRS Acquiom, a managing director and general counsel for Mobius Venture Capital, an attorney with Cooley LLP, and a software engineer at Accenture. Jason has been a Techstars mentors since 2007.

  The good news is that you received a term sheet from an investor wanting to give you much-needed financing. The bad news is that now you have to try to understand what all this legal jargon means and how to negotiate for the best possible deal. So how do you do that?

  First, realize that you’ll never be as good at negotiating a term sheet as an investor who regularly invests in startups. You’ll also never be as good as his lawyer.1 So, as a first step, make sure that you have good legal counsel.

  But that doesn’t mean that you should just send your lawyer the term sheet and say, “Finish it.” There are too many important issues to deal with and you need to have a working knowledge of what the terms mean, which terms matter, and what some of the trade-offs are that your business will make should you accept certain provisions.

  In general, there are only two things that investors really care about when making investments: economics and control. Economics refers to the end-of-the-day financial return the investor will get and the terms that have direct impact on these economics. Control refers to mechanisms that allow the investors to either affirmatively exercise control over the business or to veto certain decisions the company can make. If you are negotiating a deal and an investor is digging his or her heels in on a provision that doesn’t affect the returns or control, they are probably blowing smoke, rather than elucidating substance. Or perhaps they aren’t that sophisticated or, worse, are just jerks.

  There are a lot of terms in every term sheet,
but you should focus on terms like pre-money valuation, liquidation preferences, board of director elections, drag-along rights, and protective provisions. Most of the other terms you’ll see in a standard term sheet aren’t really all that important. If the person you are negotiating with thinks they are, this is important information for you to know before entering into a business partnership with him. It may mean that they are detail oriented and will want to be highly involved in all of your business decisions, or it may mean that they are clueless about the important terms. Either way, that’s valuable information.

  Many of these terms have interdependencies and it’s important that you understand how terms such as option pools, warrant grants, and the election of independent board members will affect economics and control. For example, what might look like a great pre-money valuation might not be if the investor is demanding a larger option pool or grant of a warrant—each of which dilute your ownership.

  When you do sit down to negotiate, be honest and forthright. If you are dealing with a reputable investor, talking about the trade-offs and issues usually allows the parties to become more comfortable with each other and work better later as partners. These negotiations often forge the future relationship of the entrepreneur and investor.

  For detailed information on important terms such as pre-money valuation, liquidation preference, board of director elections, drag-along rights, and protective provisions, see the extensive term sheet series of blog posts written by Jason and Brad at Feld.com, or the VentureDeals.com website. For in-depth coverage of VC terms from the VC’s perspective, check out their book, Venture Deals: Be Smarter Than Your Lawyer and Venture Capitalist.

  David Cohen and Nicole Glaros in a mentoring session.

  Note

  1Jason and Brad have written a book, Venture Deals: Be Smarter Than Your Lawyer and Venture Capitalist, to help you achieve this.

  Chapter 68

  Focus on the First One-Third

  Brad Feld

  Brad is a partner at Foundry Group and one of the cofounders of Techstars.

  Raising money from angel investors can be a daunting task. One useful trick that we teach founders at Techstars is to focus on getting the first one-third of the money committed. If you’ve gotten a third of the round committed, you’ll often find that the rest of the financing will come together quickly. The reason is that angel investing is best understood as a social sport. If you’ve got one-third, you have a lead investor, or at least a lead group of investors.

  Generally speaking, you are going to encounter three types of angel investors. The first type is the potential leads. They’re not going to play wait and see. They’ll lead the round if they get excited about it. This is generally the same class of angel investor who will also say no quickly. Recognize that this is great in either case. At least you’ll know where you stand with this type of angel investor. Generally, focusing on the first one-third means focusing on this first type of angel investor.

  The second type of investor (and they’re very common) is the kind who will not commit early on but will want you to keep them in the loop. These are the maybes. The maybes are great to collect, but I’ve seen too many entrepreneurs spend all their time trying to convert maybes into lead investors. My advice is to collect the maybes, ask them if you can tell others that they’re interested, keep them posted on your progress, and get back to identifying more people who have the potential to lead.

  The same angel investor will behave differently in different deals, so it’s dangerous to stereotype any particular prospective angel investor into one of these first two categories.

  The third type of angel investor is the most dangerous. They’re the angel investors who aren’t really angel investors. You may mistake them for the first type, and they’ll ultimately cause massive distraction and delay. See Chapter 58, “Beware of Angel Investors Who Aren’t,” for more types of dangerous angel investors you should avoid.

  Segment every angel investor you meet into one of these three buckets as quickly as possible. Focus on the first type and imagine them making up one-third of the funding pie. Once you’re there, push aggressively toward the closing with the goal of moving the maybe group into the yes-or-no group. You’ll need to set a closing date that the lead group is happy with or you won’t have any leverage to move the second type of investor off the fence.

  Usually the second and third pieces of the pie will come together much more quickly. The committed angels will start calling their friends to get the deal done, and some of the maybes will fill in the gap.

  It doesn’t always work this way, but there does seem to be something magical about focusing on the first third of the pie. After all, no one likes to play a team sport by themselves.

  Theme Six: Legal and Structure

  While team issues are one of the top startup killers, things left undocumented are a close second and can lead to fatal problems. Too many founders ignore legal and structural issues, assuming they can deal with them later. Sometimes they’re right. Sometimes they’re dead.

  At Techstars, we have active early engagement from startup lawyers, accountants, and bankers. They provide free advice early in the program and make sure the companies get formed correctly. Most entrepreneurial law firms, accounting firms, and banks will do the same for your company, if you ask. In addition to being good business development activities for them because they’d love you to be their customer as you grow your business, it’s also an important and effective way for them to engage in the entrepreneurial ecosystem.

  We’d never recommend that you go overboard on the legal and structure issues. There are simple and cost-effective ways to do things right. Taking the time now to understand the most important issues can save your startup (and you) a great deal of pain down the road.

  Chapter 69

  Choose the Right Company Structure

  Brad Feld

  Brad is a partner at Foundry Group and one of the cofounders of Techstars.

  When you start your company, you need to choose the type of corporate form you want. There are two logical choices (S-Corp or C-Corp), and a third one (LLC) that pops up occasionally. The best choice depends on the financing path you are ultimately planning on going down and how you want to deal with taxes.

  S-Corp: If you are not going to raise any VC or angel money, an S-Corp is the best structure because it has all the tax benefits and flexibility of a partnership—specifically, a single tax structure versus the potential for double tax structure of a C-Corp—while retaining the liability protection of a C-Corp.

  C-Corp: If you are going to raise VC or angel money, a C-Corp is the best (and often required) structure. In a VC or angel-backed company, you’ll almost always end up with multiple classes of stock, which are not permitted in an S-Corp. Since a VC or angel-backed company is expected to lose money for a while (that’s why you are taking the investment in the first place!) the double-taxation issues will be deferred for a while, plus it’s unlikely you’ll be distributing money out of a VC or angel-backed company when you become profitable.

  LLC: An LLC (limited liability corporation) will often substitute for an S-Corp (it has similar dynamics), although it’s harder to effectively grant equity (membership units in the case of an LLC versus options in an S-Corp or C-Corp—most employees understand and have had experience with options, but many don’t understand membership units). LLCs work really well for companies with a limited number of owners and not so well when the ownership starts to be spread among multiple people.

  While there are several advantages of an LLC over an S-Corp (the ability to issue different classes of securities, ease of setup, informality of operating agreements, lower state taxes, and non–U.S. investors), venture funds typically cannot (or don’t want to) invest in LLCs. When a VC invests in an LLC, she risks getting assessed an income tax called UBTI (unrelated business tax income). Investors in venture funds frown upon this type of income and most VCs have a provision in their fund agre
ements that they will use best efforts not to bring UBTI into the partnership. As a result, VCs shy away from investing in LLCs.

  The able-minded entrepreneur says, “Yeah, but I’m not ready for venture capital yet. I’ll just do an LLC now and convert to a C-Corp when I raise VC in a year.” Okay, but to convert an LLC into a C-Corp, one has to go through a complete merger whereby a new entity is created, which usually devolves into a wholly owned subsidiary, and that subsidiary is merged into the LLC, leaving the LLC as the subsidiary of the parent. In short, it’s complicated and makes the lawyers and accountants some extra cash. Yuck.

  In contrast, converting an S-Corp to a C-Corp is simply a “check the box” tax election (or—actually—unchecking the box). This can be done in a day with a single tax form. No lawyers, no accountants, and minimal expense. Therefore, while the LLC has some benefits, the costs of converting the LLC into a fundable entity are substantially higher and usually not worth the additional effort.

  An established lawyer who does corporate work with early-stage or VC-backed companies can set this up quickly, easily, and inexpensively for you. Such a lawyer is often the best source for the equivalent of a best practices template, since this is routine work and requires simple boilerplate documents and filings.

  Chapter 70

  Form the Company Early

  Brad Bernthal

  Brad is an associate professor of law at the University of Colorado. He is the founder and director of the Silicon Flatirons Center’s Entrepreneurship Initiative. Launched in 2008, the Initiative creates a high velocity of interaction between the CU campus and the Front Range’s high-tech entrepreneurial community. Brad has been a Techstars mentor since 2008.