Next Things First

I have a feeling we are going to be posting a lot over the course of the next few months on the unsustainable pressure on angel investors – but for now, let’s celebrate the fact they are stepping up to the plate when the guys getting paid to do the job shy away.  John Cook writes this today in TechFlash:

Despite the struggles in the economy in the latter half of 2008, members of the Alliance of Angels still invested near record totals last year. The Seattle angel group said today that its members invested $6.4 million last year, a 64 percent increase over 2007 and the second highest investment total since the organization was founded 11 years ago.

For those in Seattle – or those who are looking for an excuse to hop the next flight – check out the meeting of innovateHealth tomorrow night. We will be joined by Michael Burcham (Paradigm Health, Theraphysics) and will be discussing the opportunities for innovation created by the Obama administration’s health care reform plans and the bottomless cratering of the economy.

It will be a great chance to see all those folks who you had no idea were working in health care too and to strike up a vigorous debate about health care issues without embarrassing yourself in front of your friends.

RSVP to events@innovate-health.org.

InnovateHealth blog: innovatehealth.wordpress.com

John Cook posted a very interesting piece on VC deal terms last week – for those of your that missed it, take a look:

Of the 128 companies surveyed by Fenwick & West, 41 percent of the deals included liquidation preferences — special rights that allow VCs to cash out first if the startup is acquired. That’s about the same level as the previous quarter. Even more interesting, is that VCs increasingly got liquidation preferences that required two to three times of the initial investment. Fenwick found that 23 percent of VCs got multiple liquidation preferences last quarter, up from 16 percent in the third quarter. That’s bad news for entrepreneurs, since if a positive sale occurs there can be little leftover for the founders who conceived the business.

To read more, click here.

Since liquidation preferences are a term that always gets under our skin, we posted a few comments to John’s article. Since so many of our colleagues use these preferences (and we know they have a place) we tried to be nice. However, I would bet that data would show these preferences have a surprisingly destructive  impact on value. Since they only really “matter” in underperforming companies – or at least deals which were unrealistically assessed at the time of the investment – one has to wonder what impact knowing they are going to see disproportionally less of the upside has on management teams.  Someone has to come in and run the business every day… and I don’t know any VCs who want to have to step in and do that work.

…Terms like liquidation preferences have grown in popularity to offer downside protection – and in certain cases (especially in overly complex capital structures) they can serve an important purpose.

However, they have become emblematic of the personality disorder facing the venture capital industry over the past decade. Ours should be a business of aligning incentives with entrepreneurs and getting actively involved in building value. As preferences layer on top of preferences, however, it is not uncommon to see the returns gobbled up before management can even get a seat at the table.

While there is a need to mitigate downside risk and protect later stage investors, I worry that this deal term is over used – and often times used incorrectly. When success is created by motivating entrepreneurs (or at least not “demotivating” them), deal structuring is important. As is the perception of being “in this together”.

I remind myself often that “getting it because we can” can not be the basis for VC/entrepreneur negotiations -even during this sort of an economy.

Since posting last week about our memories of Rick Carlson, I have been overwhelmed with the response from Rick’s friends and colleagues. Accordingly, I thought it would be valuable to link to The Personal Genome, a blog where Rick would occasionally post. He was working on a regular column there – and TPG posts the rough draft here.

As usual, John Cook is stirring up an interesting debate over at Seattle’s TechFlash blog.

Yesterday, he linked back to a piece I wrote in early January on the need for the government to include support of early stage ventures in the stimulus plan. You can find that thread on TechFlash here. This post generated considerable commentary, including our response:

…many comments ignore the fact that if there wasn’t a substantial capital constraint facing early stage investing there wouldn’t be so many high quality companies starved for capital.

Many of the comments are correct to point out that in some situations angel networks and incubators may better serve the early stage than traditional VCs. Even better, many point out that ‘built to flip’ VCs are not the proper agents to drive recovery/stimulus investing.

However, there are regional and industry specific investment networks and firms that have considerable infrastructure (around process, network and human capital) which could be leveraged to get government dollars to work in the early stage. Each of these groups could efficiently put a fraction of the dollars Friedman references to work ($50-100 million). This would have extremely positive implications for the innovation economy.

Without focus on efforts like this – as well as attention to the stalled exit environment … the outlook for those of us focusing on new start ups and early stage venture is looking increasingly bleak.

John then went out an interviewed many of Seattle’s top VCs and posted this piece on the blog. The tone of the VC community was decidedly negative and we posted the following retort:

…Private equity is moving through an industry wide identity crisis – culminating in this week’s upcoming screaming match over the tax treatment of private equity manager’s carried interest. When all of these managers are heard for the first time, complaining in unison about their tax rate, I fear it will be the nail in the coffin for the reputation of our industry.

This is especially true for venture capitalists – who have been relatively innocent of the abuses of our gluttonous big brothers in buy out funds. However, we certainly have abdicated responsibility for the early stage (and to our investors) as we have rushed to support later stage investments with significant revenue and years of positive EBITDA.

While your panelists are correct to point out that angels have been recently left with responsibility for “filling the funnel” with early stage investments, it is important to note that these angel networks are strapped, have inherent limitations and can not bear the full burden for fueling the innovation sector.

Brad Silverberg is correct in pointing out that start ups can benefit from significant capital efficiency. Technology costs continue to come down and, in this economy, people and space cost considerably less. However, existing VC funds (that some argue are “flush with cash”) are not taking advantage of these market opportunities. And for obvious reasons.

Investors in existing VC funds are not certain to reinvest (and the prospect gets less certain by the week). 2009 promises to be a low point for LP commitments to funds. VCs are incented to keep powder dry and see their existing portfolio companies through the long winter. Accordingly, the few new investments that are made in these portfolios will face intense scrutiny.

This is exactly why additional capital, unfettered by these considerations and guided by experienced venture fund or angel network managers, is so needed.

As Andy Sack points out, changes to fund structures will be needed (especially around management fees – perhaps this is an area to more widely introduce budget based management fees). However these necessary tweaks are no reason to throw the baby out with the bathwater.

Stimulating a resurgence in back-to-basics venture capital (serious value added from roll-up-their-sleeves VC managers) would have a positive impact not only on the economy but also on the public perception of our asset class.

A big thanks to John Cook and the folks at TechFlash for keeping such a relevant and vigorous debate going…

We are on a short year-end break …

We greatly appreciate all your support as we launched the blog this year! We are looking forward to more spirited discussion (and perhaps even finding some solutions to the health care and venture capital messes) in 2009.

Best,

Rob, Charlotte and all of us at Faultline