Deal (Flow) or No Deal

As an entrepreneur or angel investor, you may ponder what factors under your control can lead you to choose successful ventures. Every angel investor and venture capitalist has made regrettable investment decisions, and most entrepreneurs have at least one failed venture in their past. We try to learn from our mistakes, but what proactive steps can we take to reduce the probability of investing in or starting businesses that are doomed to fail? One answer is common sense to venture capitalists; however, I often find that entrepreneurs, and even angel investors, fail to recognize the value of deal flow.

Professional investors understand that money and deal flow are the key inputs of their business, as they are in the business of building investment portfolios, which diversify risk and seek alpha. For example, in order to build a robust portfolio of 20 early-stage companies, you may have to look at 800 business plans. These investors understand that the more deals they review, the better their chances of finding deals they like.

Most angel investors are looking to make a few illiquid investments in startups, and most entrepreneurs can only develop and manage one business at a time. Angels understand the high level of risk associated with these investments, but they represent only a small fraction of an overall portfolio, which typically includes stocks, bonds, and real estate. Entrepreneurs assume responsibility for the inherent risks of a new venture and relish the challenge of achieving a successful outcome. Too often, neither the angel nor the entrepreneur wants to look at hundreds of business plans before making a decision. They are too busy chasing alpha!

Nevertheless, deal flow is far more valuable to them than they may realize. Because they are not able to diversify their risk as effectively as the professional fund manager with a large pool of capital, making the right choice about a new business is paramount. And the only way to systematically improve their probability of successful choices is to increase their access to more opportunities.

If you are eager start a business or make an investment, you will pick amongst your available options. But what if you are not looking at enough options? Some startups have a great idea, but lack experienced management. Some talented management teams have lousy ideas or terrible market timing. Some ventures are so promising that a dozen other players are already vying for market share. Some ventures sound too good to be true, and if you dig deep enough, you will find the fatal flaw. If you have enough deal flow, you are forced to separate the wheat from the chaff. More often than not, entrepreneurs and angels make choices with too limited a set of opportunities.

If you have invested in a startup or founded a company, ask yourself: “how many business plans did I review or how many business models did I conceive and research before making a decision?” If the number was less than ten, and you have been wildly successful, then I commend you. If you have not been as successful as you would like, you might ask yourself: “how can I improve my deal flow before making my next move?”

What does $50 Oil Mean for Clean Tech?

Earlier this year when oil was on track to reach $150/bbl, it was hard to find an investor class not interested in clean tech. Jim Cramer was recommending stocks that should profit from the boom in wind power generation, which he cleverly nicknamed his “Windex.” A solar ETF was introduced earlier this year on the NYSE with the ticker TAN. Hedge funds and banks lined up to loan money for ethanol and biodiesel refineries. Private equity shops, which had built portfolios of coal and gas fired power plants during deregulation, were setting their sights on geothermal, waste-to-energy, wind, and PV generation. The venture capital industry placed faith, resources and money behind clean tech as the “next big thing.”

Both Presidential candidates have continued to stump for Cap and Trade as well as for government funding of alternative energy research and infrastructure projects, like a new version of JFK's Space Race or FDR’s CCC and WPA. However, does a return to cheap fossil fuels spell the end of our clean tech revolution?

Unavoidably many alternative energy infrastructure projects will be canceled, promising companies will fail, and new technologies will be starved for capital. Public support may wane after November as consumers see their monthly gas bills drop. Indeed, the next President will find it difficult to implement his clean tech vision with no money available in Federal or state budgets and with traditional industries in financial distress. We have seen the short memory of the American consumer before, and broken political promises are a way of life to us.

Yet, I am optimistic. High fuel prices may have pushed the conservation movement to the mainstream in America, but we have simply caught up with the rest of the world. Lower fuel prices will not reduce our dependence on foreign oil, and more Americans understand how our foreign policy has been perverted by the need to maintain access to oil imports. Moreover, the impact of global warming and the health effects of pollution seem more real to Americans than in the past. I do not think we will collectively unlearn these lessons as fuel prices decline.

Furthermore, I am bullish on fuel prices once global economic activity picks up. Oil at $50/bbl will be a temporary reprieve and, in fact, will stimulate economic activity; Peak Oil remains a reality we must face. The economies of China and India remain thirsty for fossil fuels, and developed nations must evolve their energy infrastructure and conservation measures in order to maintain their standard of living in the twenty first century.

The future of clean tech, thus, remains bright. Venture capitalists will come to terms with longer investment horizons; lenders will learn the importance of hedging input and output prices; and private equity firms will have opportunities to acquire distressed infrastructure assets. Most importantly, governments must have the foresight to recognize that lower fossil fuel prices are only temporary, and that true vision and leadership are needed in energy policy. Maybe I will outline my own unsolicited public policy suggestions for the next President soon.

Life = Risk

Sorry for the lack of original content in my last two posts, but September Madness was too hilarious not to share with you and this one... well, I think there are a lot of people out there right now who might benefit from a little perspective.

March Madness Redefined

This is self-explanatory (click on the image to enlarge)...

“Price Discovery” is the Thing

Shakespeare’s Hamlet said, “The play's the thing wherein I'll catch the conscience of the King.” One of the major reasons that some credit markets are nearly frozen is the “thing” missing is price discovery.

Hamlet used a play to see whether his uncle King Claudius would flinch at the topic of regicide, so that he would know for certain whether Claudius had murdered Hamlet’s father, the former king. Buy-side institutions use bulge-bracket investment banks’ dealing desks to help discover the price of complex credit instruments and complete trades. However, as the restructuring of the bulge-bracket model is underway on Wall Street, the investment management business has been left holding the bag.

I would argue that although these firms were not “too big to fail,” the cumulative domino effect of Bear Stearns', Lehman Brothers', Merrill Lynch's, Goldman Sachs', and Morgan Stanley’s dramatic fall from grace has forced the buy-side to question their reliance on Wall Street brokerage firms for market insight and trade execution. Although these investment banks are finding new homes within large commercial banks—an evolution that was already underway—we cannot expect the new model to perform the same vital role in credit markets as market makers who assume significant risk. The demise of price discovery is the immediate result, as investment managers have lost confidence in Wall Street’s role of providing liquidity and clarity.

The current narrative in Washington about a government bailout, changes in regulation, a reduction in taxes, or modifying mark-to-market rules do nothing to address the need for price discovery in what have been referred to as less liquid fixed income markets (i.e., where there is no standing market for a specific security). The “play” has been suspended, and Hamlet needs a new “thing” to provide price discovery and promote liquidity for buy-side institutions to reenter the credit markets. TowerGroup has provided us with the answer, although they hid it in plain site within the list of predictions below. Can you guess where buy-side institutions will find the new play?

TowerGroup has predicted that the buy-side will be impacted in the following ways:

1. Less capital commitment from Wall Street
2. Disruption in the provision of execution services
3. Changes in securities lending services
4. Greater focus on risk management
5. Decreased buy-side appetite for structured products
6. Shift in order flow from dark pools to crossing networks
7. Buy-side opportunity to hire top Wall Street talent
8. Elevated positions of second-tier brokers, independent EMS providers, and OMS vendors

I truly appreciate your time spent reading my blog, so I tried to make it easy for you. It should come as no surprise that technology must provide the solution. Has anyone noticed that no one is worried that the equity markets will seize up? Investment banks and insurance giants are going bankrupt, regulators are seizing failed commercial banks, and the impact on industrials and retail remains uncertain. Yesterday we saw the largest point drop in stock market history, yet the equity markets remain robust and liquid. Why?

Price discovery is alive and well in the equity markets, because this function has already shifted away from the voice trading paradigm and bulge-bracket dealing desks to electronic trading platforms and crossing networks. The fixed income markets have lagged the equity markets in adopting new technology, and they are now suffering as a result. If Washington were willing to listen, they may be interested to learn that removing the most toxic loans and securitized loan portfolios on bank balance sheets will not solve the Credit Crunch. To be sure, hoarding of cash, the widening spread in inter-bank lending, lack of commercial paper, and the outcome of credit default swaps are also fueling this crisis; therefore, a multifaceted government response is required. However, promoting and providing liquidity to electronic trading platforms targeting the fixed income markets—so that credit markets can operate under uncertainty like the equity markets—should be a top priority.

ECNs like MarketAxess and TradeWeb have successfully introduced electronic innovation to fixed income, but these networks are still dealer-centric, not anonymous, and only address the most liquid fixed income markets. In the equity markets, companies like LiquidNet and Pipeline have enabled both large buy-side institutions and dealers to find liquidity for dark pools; however, you could characterize most of the less liquid fixed income market as dark and no electronic platform has achieved scale. In fact, there is only one company that I know of that has built and is operating an electronic trading network, which can electronically match orders and execute transactions within the less liquid fixed income market. Take a look at Beacon Capital Strategies, if I have peaked your interest.

TowerGroup’s predictions #1 and #8 are also relevant, because as Wall Street commits less capital to support trading in these markets, the central role of these bulge-bracket dealing desks to providing price discovery and liquidity will decrease. Beacon’s platform facilitates these dealers’ need to reduce capital commitments as well as empowers second-tier brokers to service their regional clients better. These second-tier brokers are trying to step up to fill the gap, and they need a new mechanism for price discovery as well.

The Credit Crunch is accelerating the evolutionary transition to electronic trading in the financial markets. Nevertheless, it is imperative that Washington understands that for the healthy flow of credit to resume, liquidity is predicated on not only removing fear that trading partners may fail (i.e., counter-party risk), but also promoting solutions to reestablish price discovery to essential credit markets.

In Response to Joel as “Joe Middle Class”

Joel asks in response to my previous blog, “how does this bad debt affect me if the USA doesn't purchase it?”

The argument is being made that if this bad debt is not removed from bank’s balance sheets, then the banking system will be unable to continue lending. If this happens, then everyone will be hurt, because no one can finance the purchase of a house.

Personally, I think Bush has probably stepped aside in these conversations (thank goodness!), Bernake's role is more advisory, and Paulson is basically running the show as far as the Executive Branch. Despite President Paulson's obvious conflicts of interest (e.g., he formerly ran Goldman Sachs and his Assistant Treasury Secretary recently left to run Wachovia), I honestly believe that he wants to do the right thing here. That is not to say Congress or the American taxpayer should trust his judgment implicitly, as this is a very complex and dynamic crisis, and the optimal solution is far from obvious. I would prefer to characterize his past positions, current stock holdings, and friends in high corporate places as leading to bias in his judgment, not blind self-interest. I think what is driving his self-interest now is mostly that he does not want to become the Don Rumsfeld of the Credit Crunch, and I am OK with this as his primary motivation.

I think the current proposal is inherently flawed in four respects:

1) As it has been described in the press, the bailout does not address Moral Hazard, and most suggestions being offered to exact punishment might trigger the theorized death spiral that Paulson is trying to prevent.

2) The premise that lending will seize up is predicated on all banks being in jeopardy of failure, but I have yet to hear is true. If weak banks fail, why can’t strong banks fill the gap? Is this not Free Market Capitalism, which I thought Paulson and the Republican Party has been espousing for decades?

3) There are vulture funds with billions in cash, impatiently waiting for the banks to finally admit they have been grossly overvaluing their loan portfolios (i.e., lying to regulators) so that these funds can purchase these assets at an appropriate discount. In truth, these banks have been insolvent for months, so instead of buying their toxic waste, why doesn’t the government simply seize all their assets, then move RTC style to raise funds to bail out the insured depositors? I do not know whether this strategy could work, but is there even a debate over alternative solutions?

4) This bailout plan is extraordinarily expensive to the US taxpayer, but still only puts a band-aid on the larger problems facing the financial system. Anyone heard of Credit Default Swaps?

If more people like Joel would start asking questions about whether it makes sense to use taxpayer dollars in truly unprecedented ways to bailout financial institutions that have become corrupt and bloated, we might actually encourage Washington to take a fresh look at the core problems and alternative solutions.

Why this Bailout is not “RTC Part II”

In the early 1990’s, the Resolution Trust Corporation closed or otherwise resolved 747 Thrifts with total assets of over $390 billion. This period played out over several years, and is now referred to as the Savings & Loan Crisis. The RTC created equity partnerships for private sector partners to acquire interests in asset pools of these failed Thrifts. These private sector partners controlled the management and sale of the pooled assets and made distributions to the RTC. Prior to utilizing the equity partnership structure, the RTC had conducted bulk sales of these asset portfolios; however, heavy discounting made this unacceptable. By partnering with the private sector and retaining a stake in the asset portfolios, the RTC was able to realize strong returns like the private investors, and the alignment of incentives was assured. Ultimately, it is estimated that the RTC bailout still cost taxpayers approximately $125 billion, but it was remarkably successful.

So-called market experts have been saying for more than a year “not to worry” this time, because they do not expect so many banks to fail as a result of the sub-prime mortgage mess. Of course, what they failed to acknowledge was that the S&L Crisis involved the failure of small community Thrifts to manage their balance sheets, not the entire financial market’s failure to do so. Now our federal government has requested $700 billion from Congress to buy up distressed assets as part of its plan to halt the worst financial crisis since the 1930’s. The press, in typically ignorant fashion, is describing this as RTC Part II.

The Treasury Department sent Congress a two-and-a-half page outline to suggest legislative language that would create an RTC-like government entity with the authority to buy the toxic assets of U.S. financial institutions. As taxpayers, we need to understand that there are three critically important differences from the days of the RTC:

(1) Treasury is not asking for a government institution to hold the assets of failed banks and then sell them off; they want to purchase this toxic waste from a wide range of financial institutions, hold them until better times, and then try to sell them. Sounds like a pipe dream, I would not invest my money in.

(2) The RTC was charged with raising money from the sale of seized Thrift assets to help fund the shortfall from the government-insured deposits of little people like you and me; the current Treasury proposal calls for an entity to transfer wealth from taxpayers directly to the balance sheets of commercial banks. The former was a private fundraiser to pay for government guarantees to individual checking account holders; the latter is a bailout subsidy for bankers.

(3) The failed Thrifts of the 1990’s were holding mostly commercial mortgages; however, today’s toxic assets consist of mostly residential mortgages, CMOs and other securitized mortgages, which have been cut up into tranches (with the servicing rights sold off). Good luck putting Humpty Dumpty back together again!

The true cost to the taxpayer of this bailout proposal is impossible to calculate today; nevertheless, it will likely make the S&L Crisis and RTC action look like a very minor historical event in financial history. It appears to me that Treasury is asking taxpayers to be the high bidder for this toxic waste. Banks will obviously sell this waste to the highest bidder, so I have to assume that this government entity will only buy up what the private sector won’t touch. Moreover, who can sell to this government entity and by what date must they be holding the assets in question to prevent arbitrage at the expense of the taxpayer?

So many questions loom around such a brief, yet significant, proposal that is now in the hands of a Congress, which is far more skilled at debating the fate of Terry Schiavo than the fate of our economy. They are being pushed by Treasury and Wall Street to act quickly, which is never a harbinger of successful regulatory action. The fact that this is an election year only adds to the uncertainty.

Just look at SEC Chairman Cox’s quick action last week to ban short selling of 799 financial stocks for at least 10 days. Did he simply forget that he removed the uptick rule on writing shorts—which had been in place since 1934 up until last year—and reinstating this rule would have sufficed? Besides, it is not at all clear that the downdraft of trading in the financials last week was really about short writing as much as it was a rush to get out of these stocks, because no one knew who would be the next Lehman or AIG.

I suppose this would not be a good time to request a “bail out” of the 10,000,000 children in the U.S. without health insurance? I guess that Iraq reconstruction, preventing bankruptcy for banks that sustained huge profits by underwriting bad loans, and subsidies to corn producers to produce ethanol are more worthy uses for our tax dollars.

Where in the World to Startup?

I am not a fan of rankings — whether for web pages, business schools, or NCAA football — because any methodology that attempts objectivity is prone to bias and error. Nevertheless, the World Bank has developed an interesting set of rankings of the friendliest countries to startups and small businesses as part of their Doing Business Project, and I think it is worth a look. I am just guessing, but there must not have been a metric for the number of Russian tanks that might blow up your business, otherwise Georgia probably would not be ranked fourth in the world for starting a business.

At least the U.S. is still in the top ten for most of these rankings. Although... did the World Bank include a metric for major financial institutions going bankrupt or needing government bailouts on a weekly basis?

How Much is my Company Worth?

This is the most common question we receive at Kosch Capital. Whether someone is raising venture capital, establishing a strike price for warrant coverage in a private company, selling to a strategic buyer, or negotiating with a private equity sponsor, every deal starts and ends with this question. I do not need to add to the voluminous tombs of textbooks on securities analysis, valuation theories, and capital structures. Moreover, you can Google the terms WACC, Terminal Value, Discount Rate, Cost of Capital, Cap Rate, etc., and hopefully Wikipedia will have an accurate entry and useful references. Instead, I would like to explain some common misperceptions and pitfalls in practical terms.

First, you should expect that others will never view your company’s future prospects and, thus, value in a more positive light than you do. Whether this is because you know better how to mitigate these risks or you are simply less risk averse, expect that others will always haircut your projections and apply a higher discount rate to your projected cash flow. You should always openly explain to an investor or an acquirer how you manage risk, but at the end of the day they can walk away from a deal; you’re stuck with it, so you are likely to be more optimistic.

Second, when looking at public comparable company valuations, your smaller private company probably cannot command the same multiple. There is a liquidity premium. Those companies are efficiently priced by the market, and their investors can get out at any time; whereas, your company’s stock has no certainty of value or liquidity until you find a buyer.

Third, growth is extremely valuable—but hard to predict—and even harder to agree on. If you built a discounted cash flow (DCF) model for your company, you know that most of your valuation was contributed by the terminal value. You applied a discount rate to your free cash flow projections for the next 2, 3, or 5 years, but then there was a big fat number for everything after you gave up making predictions, and your growth rate assumptions had a huge impact on that final number. When so much value is determined by what happens five or more years from now, good luck on finding agreement between buyer and seller with this method. Thus, expect to compromise.

Fourth, your company is worth more or less to different people. I am not talking about differing perceptions of growth and risk, like I have described above. For a strategic buyer or investor, your company may provide new customers, new distribution or new products, and efficiencies of scale might be gained by combining like businesses. Some strategic buyers may also be interested in eliminating a competitor. All of these value propositions bring something to the table that you are less likely to find with a financial buyer, such as a private equity fund. On the other hand, a private equity fund may be more aggressive about applying leverage or might be acquiring your company as a strategic add-on to one of their other portfolio companies. Therefore, sometimes you may find that a financial buyer can pay a higher price than a strategic buyer.

Fifth, the cost of capital for potential acquirers and the IRR expectations of potential investors dictate what valuation they can accept. Private equity funds typically use leverage when they acquire companies. If the amount of debt they can raise against your company’s assets and cash flow decreases and the cost of that debt increases, then that acquirer will not offer you as high a valuation for your company. We originate these loans at Kosch Capital, often referred to as leveraged loans, and the coupon rates have gone up and debt coverage ratios have gone down since the Credit Crunch began last summer. Similarly, a venture capitalist is looking at the current economy and thinking that it might take you longer to grow your business and execute a successful exit; therefore, in order to meet their IRR expectations, they will not give you as high a pre-money valuation as they would have two years ago when the economy was booming.

Each of the five points above share a basis notion: when you step into the other party’s shoes, you get a different perspective. We all want to negotiate the best price and “not leave money on the table,” but if the buyer or investor does not feel that they are getting a good deal, they will not close. I prefer to shift the expression a little… “leave something on the table for the next guy.” Valuation is an art, not a science, and the only thing we can all be certain of is that projections are usually wrong; therefore, if you really want someone else to provide you liquidity or capital for growth, understand that the deal has to benefit everyone.

Ok, Then… Where are They Hiding all of the Cheese?

Congress has been busy grandstanding about how they are going to solve the high price of oil by cracking down on speculation in the oil markets. In fact, not less than nine bills have been introduced by our elected officials, who clearly have no idea how futures markets actually work or why they even exist. Of course it is very convenient to blame hedge funds and other speculators for today’s oil prices, instead of looking at the structural problems of our petroleum based culture and the lack of leadership and political willpower to support significant investment in technology development or encourage conservation since the first oil crisis began in 1973.

Interestingly enough, the Federal government purchased and warehoused cheese during the 1970’s in an effort to support cheese prices. Prices are driven by supply and demand, so if you want to raise price levels in the short term, you must limit supply. Congress apparently believes that hedge funds are hoarding barrels of oil in their office suites in New York and Connecticut today. In truth, the futures markets and speculators are all that stands between $140 a barrel and $250 a barrel. Let me explain…

When oil prices are going up, oil refineries and end-users are more likely to hoard oil at today’s prices, because they expect that if they wait to purchase supply later, the price will be higher. Instead of hoarding, they can hedge this market risk through trading in the futures markets, and speculators support this hedging strategy by taking the other side of the trade. Similarly, producers are less inclined to pump and ship as much product today if prices are expected to rise tomorrow. Again, hoarding the cheese is prevented by the liquidity of a robust futures market, which allows producers to hedge instead of to hoard. Finally, if an oil company is considering whether to invest capital in new production, they must consider whether it will still be economically viable if current oil prices were to drop. Again, the futures market provides a trading strategy to minimize these risks to producers and their lenders.

The fact is that more trading and more participants—including speculators—in futures market drives more efficient pricing for hedging strategies that prevent price bubbles from developing. Moreover, a seemingly thoughtful proposal in Congress to limit speculation by raising margin requirements from approximately 10% today to 50% would do more than just discourage some high stakes speculators; it would have the unintended consequence of raising financing costs for fuel distributors, forcing them either not to hedge—thus increasing risk of bankruptcies and supply disruption—or to raise prices to end users to compensate.

Congress needs to look elsewhere for solutions to high oil prices. If they succeed at driving speculators from the futures market, it will have the same effect as Congress hiding the cheese.

Sorry, Dorothy, No Easy Way Back to Kansas this Time

If we collectively click our heels together, can we avoid a recession and a protracted bear market? I suppose we have not tried this yet, but certainly all other forms of wishing we were someplace else have failed. I have been a serious bear for more than a year now, so I am not just the latest Chicken Little burned by the market this week. In fact, I have been short the market for months, so I have some extra change in my pocket this weekend.

It really does not matter who is ahead in the presidential polls, what Bernanke says, or how much of our tax dollars Dub’yuh sends us by mail, we are faced with a recession and a bear market. All I want to know is how far down the death spiral do we go and will we continue to dig in our collective heels in vain, thereby extending the pain for many quarters. For those eternal optimists (also known as pundits on TV, retail stock brokers and politicians), can you please tell me how we ignore the following facts?

• Hedge fund meltdowns and bond defaults
• Bank failures and corporate bankruptcies
• Record foreclosure rates and looming credit card defaults
• Unemployment rising and food prices soaring
• Oil prices at new record levels
• Consumer confidence at historic lows and a weak dollar
• Polar icecaps melting (sorry, that’s just piling on)

I know these optimists will say that despite all of this, it is always darkest before the dawn; however, that wonderful idea only applies at the end of the death spiral when we experience complete capitulation (including from these optimists). I am afraid that the worst is ahead of us, not behind us.

You had better look at Japan or many Latin American nations if you want a history lesson on what we may be facing today. Can you spell S-T-A-G-F-L-A-T-I-O-N? Anyone? Anyone?

An even scarier prospect is how these problems can ripple through our global economy…

Of Cap Tables and VC Term Sheets

Unless you are operating a sole proprietorship, you should maintain and understand your capitalization table, which you can maintain as an Excel spreadsheet calculating how much you and others own of your company. For those of us that want to appear too busy and sophisticated to spell it out, we call it our Cap Table. Your company may be structured as some form of Partnership, S-corp, or LLC, in which case your cap table may consist of general partners, common stock owners, or LLC members holding stakes of similar class. Conversely if you have a C-corp, you may have stakeholders with common stock, different classes of preferred stock, stock options and warrants. If your cap table is still fairly simple—but you plan to raise venture capital—get ready for your cap table to become more complex and frequently misleading.

Venture capitalists typically structure their investments as preferred stock, and each VC firm has their own boilerplate Term Sheet they like to use. Many terms that define this preferred stock can chip away at the value of your common stock and your employees’ stock options. These terms can be difficult to plug into your cap table calculations. Liquidation preferences, ratchets, convertible cumulative dividends, redemption rights, rights of first refusal, and escrowing of founders equity are not term sheet legalese you can gloss over; you must understand the impact these terms may have in various scenarios.

The complexity only increases if you have more than one round of investment and/or more than one VC involved. If you are not careful, you can find your common stock devalued to the point of worthlessness in all but the rosiest of liquidity scenarios. To be clear, many of these terms are necessary for all but the most foolhardy VCs. You must remember that VCs are not in the business of awarding grants and they have a fiduciary duty to protect the investors in their funds as best they can. Nevertheless, every term sheet is a starting point from which to negotiate terms that may impact the value, ownership, and control you expect to maintain, and you need to focus on more than just the valuation and size of the proposed check.

You should consult your financial advisor, investment banker, corporate attorney, medicine man and mystic before negotiating or signing a term sheet; however, anyone whom you ask for advice MUST have experience with venture capital term sheets… and most I-bankers and attorneys do not. You must find advisors who have been down this road before.

Here are some things to consider regardless of how confident you are in your ability to understand and negotiate terms:

• Raise more money than you think you need for the next 12 months; rule of thumb is about 50 percent more;
• Control the board as long as possible; consider what voting rights a VC may have without board control as well as what board decisions should require a super-majority;
• Insist on employment contracts with cash and equity guarantees upon termination or a liquidity event;
• Encourage competition among interested lead investors; the easiest way to negotiate terms is to have more than one term sheet in hand.

The Green Business Summit... next week!

I would like to recommend The Green Business Summit next week on June 5th in Falls Church, VA. This event is hosted by the Wharton Club of DC, and I will be speaking on a panel entitled "Investments in Green Businesses." The summit will examine business opportunities; finance and investment strategies; legal, tax and regulatory implications; clean tech; implementation factors and business sustainability issues; key international issues; oceans, climate and coasts; and the greening of government and procurement. For more information and to register, please go to: http://www.whartondc.com/article.html?aid=1064

Find Your Dutch Uncle

If you are considering a new venture, first find yourself a Dutch Uncle. If you want to run an existing business effectively, find yourself a Dutch Uncle. If you are considering whether or not to jump off a cliff, definitely find yourself a Dutch Uncle. So what is a Dutch Uncle?

There is an old English expression that refers to a Dutch Uncle, which is a person willing to give you frank and uncensored feedback. The dilemma of leadership is that it is lonely at the top. The dilemma of entrepreneurship is that your friends do not want to tell you that your baby is ugly. Good leaders cherish the subordinate with the courage to tell them when he is being either an ass or a fool. A wise entrepreneur will listen to her employees and customers.

Put simply, you cannot plot an accurate course without feedback. Without a Dutch Uncle, you may get lulled into believing sycophants, which typically come in the form of friends, relatives, and employees. This is not to say that your Dutch Uncle is always right. At the end of the day, you must place you bets and take your chances like in Las Vegas.

By revering leaders and entrepreneurs who ignored naysayers and the conventional wisdom to find great success, we can too easily draw the conclusion that every Dutch Uncle is a road block, which we should drive blindly around. You ultimately must decide what is right and live with the consequences of your decisions. There is no doubt in my mind, however, that more honest feedback and expression of opinion will lead you to make better decisions.

As a final note, your Dutch Uncle does not have to be from the Netherlands or even your uncle; that is just a bonus if you find it.

Assume at Your Peril!!!

If I were only allowed to give you one piece of advice as a budding entrepreneur, it would be: avoid assumptions. Obviously assumptions are part of everyday life and becoming an entrepreneur requires comfort with uncertainty. However, most failures can be traced back to one or more bad assumptions.

Believing in the marketability of a product or service that cannot find its market is the most fatal assumption. I call this the Contemplate Your Navel Test, where instead of asking potential customers their wants and needs, you simply keep your eyes down and fixed on your belly button while assuming that your buying behavior will mirror the market.

Assumptions regarding money are often fatal as well. Do you know how much money it will take to develop a product and file, prosecute, maintain and defend your patents? Do you know how quickly your customers will pay you versus the credit terms suppliers will offer you? Do you know what inventory levels you will have to maintain? What gross margin you can your market support, and for how long? What marketing budget will be necessary to drive your sales projections? Of course, you cannot answer all of these questions today with perfect accuracy, so you must do the best you can with limited resources and imperfect information.

Assumptions linked to timing are also of critical importance. How many businesses have you heard failed because they were ahead of their time or too late in a crowded market? How many more have you seen grow during an economic boom, only to crash during a recession. Making incorrect assumptions regarding how your company will fare in a dynamic and competitive marketplace or a recessionary environment is common. We all want to believe that we are simply better than our competition and that the good times will roll on and on. But we usually are not, and they do not. It is wrong to believe that successful entrepreneurs always view their glass as half full. If you want ensure that you have water to drink, then do not assume that a drought will never occur.

Bad assumptions also come up in the more mundane, day-to-day management of your business. For example, say your supplier has promised delivery of raw materials by next Tuesday. Do you assume that this will happen and, thus, schedule a production run for Wednesday? What assumptions are you making about this supplier’s past performance or their control over shipping and delivery? Similarly, if your customer has asked when you can deliver a finished product, do you assume that you will be able to assemble, pack and ship by the end of that week, or should you give yourself a little leeway for Murphy’s Law. While you may want to please your customer by promising delivery by the following Monday afternoon, if you fail to meet this promise, you may damage your reputation.

So how can you manage for uncertainty and avoid assumptions? The answer is that you minimize assumptions when possible, identify your unavoidable assumptions, and then expect the unexpected. This may seem like too easy a solution, but in practice it is very challenging. Most of us like to be optimistic and prefer action over analysis; however, a ready-fire-aim approach is no way to conduct an offensive in battle or business. Instead, here is a typical thought process I try to employ before making a decision:

1. What assumptions underlie my decision?
2. Can I test or prove the validity of these assumptions prior to acting upon my decision?
3. Looking at the remaining unavoidable assumptions, how would my decision change if these assumptions are wrong?
4. Can I modify my course midstream or should I alter my path now based on considering the probabilities that my remaining assumptions are wrong?
5. What key observations and measurable parameters pertaining to my assumptions should I track going forward to determine whether my decision is still sound?

This thought process may seem too clinical at first, but I think you will find that after reducing it to practice a few times, it will become second nature. When successful and experienced entrepreneurs speak of “instinct” and “common sense,” a lot of this boils down to a practiced thought process to identify an opportunity or threat, assess feasible solutions, avoid unnecessary assumptions, and manage for unavoidable uncertainty.

Low Tech is Bringing Sexy Back

At some point we must drop this distinction between high tech and low tech businesses. Frankly the terms have become outmoded, like the terms “space age” and “modernism,” which describe decades-old design styles. With computers and other digital technology pervading every research center, business, and household and with scientific advances accelerating in areas such as material science, medicine, and mechanical engineering, how can anyone draw the distinction between what is high tech versus low tech?

Many would still use the label of low tech to describe fields of research and business outside of the traditional investment scope of the venture capital industry. By this definition low tech is everything not directly related to innovation in information technology hardware and software, biotechnology, medical devices, or the Internet. Now nano technology and cleantech have snuck into the VC lexicon, and these fields typically involve innovation in the analog world of the physical sciences. So does this mean that low tech is now sexy to venture capitalists?

The answer is unequivocally “yes!” Digital technology is merely a tool towards an end; however, for the past 30 years we have focused on tool building. Now that high technology pervades everything, we are witnessing the commoditization of these tools (i.e., lower margins) as well as increased specialization (i.e., less market potential). Nevertheless, these tools now promote efficiency and accelerate the rate of innovation in other fields of science and business. Low tech innovation, therefore, has begun to accelerate, and the timing is perfect.

Global climate change, insatiable energy demand, food shortages, the struggle for potable water, global health epidemics, resource conservation, species preservation, aging population demands, and nuclear proliferation are challenges we must now face in order to maintain the quality of life, and even the survival of future generations. The focus of innovation has begun to shift to loftier goals than HDTV, an eCRM system, and the ability to purchase books, cars, or real estate online. To be perfectly clear, I am not denigrating these innovations. My life is better with college football in high definition, customer service reps that already know about my previous service calls, and the ability to buy almost anything online and avoid the real world shopping experience (e.g., parking, crowds and long lines). Nevertheless, high tech has now empowered us to innovate low tech, where the real action will be in this century.

We have shifted from Andrew Carnegie, Henry Ford, Thomas Edison, and Alexander Graham Bell to Robert Noyce/Gordon Moore, Bill Gates/Paul Allen, Steve Jobs/Steve Wozniak, and Sergey Brin/Larry Page as our archetypal entrepreneurs, coinciding with the shift from an analog to a digital economy. However, as digitalization and information technology empower innovation in previously low tech fields of science, both entrepreneurs and researchers should be emboldened to solve the challenges of our brave new world, whether man-made or not, and make a handsome profit in the process.

Seed Stage Capital

If you are looking to start a business with more than your own capital and sweat, then you have joined the hunt for seed stage funding. This least risk-aversive form of equity can be found from two sources: (1) the 3 F’s or (2) angels.

The 3 F’s refers to “friends-family-fools.” It is very difficult to convince someone who does not know you that your judgment is sound and your effort to succeed will be unbounded; therefore, friends and family are a typical source for seed stage money. Of course if you do not succeed, be prepared to lose a friend or pay back a family member. “Fools” is meant to add a humorous slant, but this does lead us to our next category… angels.

I am at liberty to describe angels as fools because I am one (and self-deprecation is a cheap laugh). The term “angel investor” is meant to refer to someone with enough disposable income that he/she actively looks for ways to dispose of capital with risky startups, hoping that occasionally one of these investments will produce a home run. Some angels are very experienced business executives, who can bring far more than money to the table. Other angels just have a fat pocketbook. All angels can be difficult to convince and even more challenging to predict their terms. If you don’t know any angels, one shortcut is to look for an angel group in your area (go to www.angelcapitalassociation.org). Not all angel groups are created equal, so you will have to learn more about their process and members to determine whether pitching them is right for you.

“If you would know the value of money, go and try to borrow some”

When Ben Franklin coined this phrase, I do not think he was explicitly talking about the cost of capital; nevertheless, if you have ever raised capital—either equity or debt—then you know that others value their money quite highly.

There are periods of time (e.g., 2006-2007) where lenders have forgotten the value of money. In Franklin’s era most lenders were lending their own money, unlike today’s more complex financial markets where commercial bankers, investment bankers, and hedge fund managers are lending other people’s money. While these professional lenders should still exercise the same degree of caution as if it were their own money, in practice they can be swayed by many counter motivations. Recently, this has led to overleveraging across many asset classes. What started with the mess in sub-prime residential mortgages has now spread across every other form of debt, and we have given this reaction the title of “Credit Crunch.”

While people have debated whether the Credit Crunch is the result of a crisis of confidence amongst lenders or a shrinking of available capital, I say it is neither. The Crunch is simply the hangover we are all experiencing after the raging party where lenders forgot the value of money. Standards have returned, and in some cases the pendulum has swung back too far; however, in all cases this is the result of a collective realization that money is valuable!

Franklin also said “when you run in debt; you give to another power over your liberty.” As a lender myself, you might think it odd that I would continue to quote a man like Franklin, who was so opposed to debt. The fact is that he was right, but he did not paint the whole picture. Leverage can be a very powerful tool to fuel growth and accelerate return on investment. Moreover, debt in all its forms is significantly cheaper than equity, so if you need cash to grow your business, swearing off debt like Franklin is foolish. HOWEVER, there is no free lunch, and a more reasonable cost of capital comes at its own price, which Franklin termed giving power over your liberty to another.

Private equity firms have proven repeatedly that layering debt onto the balance sheet of portfolio companies leads to greater management discipline and focus on the bottom line. At the same time, we have seen many companies implode unnecessarily under the weight of too much debt. So if you are considering debt to fund your business, what can you take away from all this?

Never rely on a lender to tell you how much debt you can effectively service. Whether you are buying a home, levering your company’s balance sheet, or factoring receivables, if you are truly honest with yourself, you know better than any financier how much debt you can handle without threatening your liberty. A year ago you could have easily found a lender to underwrite a bridge loan on a raw land purchase or a cash flow loan at four times EBITDA or an asset-backed loan at 80% LTV. Today, you will be hard-pressed to find a hard money lender for land acquisitions or three times EBITDA for a cash flow loan or an asset based lender who believes a 3rd party valuation report for which you hired and paid the analyst. So where lenders too liberal last year and are they too conservative today? What you need to take away from this is that the answer to that question should be irrelevant to you. You must define how much risk you are willing to take with your liberty, and use this to determine how much debt you will ask to lend.

Too often I hear equity holders ask, “How much do you think you can lend over my bank?” or admit, “I’ll take as much as you are willing to give me.” I sympathize with the desire to take as much money as possible, but the risks of debt scales with the principal you seek. Ultimately, it is in your best interests not to overreach, even when your lender has forgotten the value of money.

Talent as an Asset

If you are looking to start a business, you are probably obsessing about brand name, market strategy, funding options, product/service attributes, etc. You may be thinking about staffing requirements as well, which I would like to obsess about here.

All venture capitalists need to observe three key attributes before diving into more specific due diligence of an opportunity: (1) large market size, (2) compelling and defensible value proposition, and (3) quality management team. In fact, many experienced investors believe that an average idea with a superior team is a better bet than a superior idea with an average team. This may seem counterintuitive, but bear with me as I explain.

Don Valentine, the founder of Sequoia Capital and an original investor in little companies you may have heard of like Apple, Cisco, Electronic Arts, and Oracle, is also famous for many memorable statements he has made over the years. He has said, “The trouble with the first time entrepreneur is that he doesn’t know what he doesn’t know. After a failure he does know what he doesn’t know and can beat the hell out of people who still have to learn.” Of course, many great inventions, works of art, and ideas come from young minds; however, for day-to-day business building, experience counts.

High growth markets also tend to be highly unstable and unpredictable. In other words, today’s superior idea may be arcane tomorrow. Given these rough waters, wouldn’t you rather have an experienced crew on board? An experienced team can make the most of an average idea or even reshape it over time into a home run; however, an inexperienced team more often than not will only succeed despite themselves, or as Don Valentine has also said, “I like opportunities that are addressing markets so big that even the management team can’t get in its way.” Smart guy, huh?

Finally, I’ll retell an anecdote of a college roommate of mine. While he was attending Harvard Business School, he explained to me that regardless of subject matter every HBS class is dominated by the case study method. I was attending Wharton at the time, where many subjects were full of case studies, but accounting and finance were more dominated by lectures. My friend was complaining that since many of his classmates were learning accounting for the first time, they were getting very confused by theoretical questions postulated by the professor through the case study method. For example, his professor asked the class “should your employees’ salaries be expensed or capitalized, because aren’t people really an investment in your company?” Of course, this is a ridiculous question on so many levels, particularly when asked of students just trying to learn the language and rules of accounting; however, the philosophical element of this question is important to consider.

Talented people are an asset, and an investment in talented people is often more critical to success than any other investment in your business. Whenever possible, hire people for roles within your company, where you can say, “he/she could do a far better job of this than I could.” And, on the flip side, when you realize that you have made a bad hiring decision, first determine if there might be a better role for this person in your company. If not, get rid of them as quickly as possible. Mediocre performers aren’t just a waste of capital; they tend to frustrate and de-motivate your high performers.

Solar ETF Launched Today!

Trading under the ticker symbol TAN, this Exchange Traded Fund tracks a basket of 25 public companies that are pure plays in solar technology. With oil closing at $113.79 today, it is no wonder that public markets are bullish on the future solar photovoltaics market.

While solar may only represent a small part of the alternative energy mix to reduce our reliance on fossil fuels, this will be fertile ground for all types of entrepreneurs. The true technology innovators are focused on reducing production costs and increasing photovoltaic efficiency, which is mostly about improving scale production and experimenting with nanotech materials to replace expensive silicon. Nevertheless, millions can be made by Main Street entrepreneurs looking to build installation and service companies, particularly in regions like the Southwest and Southeast where the supply of sunlight seems limitless.

The Color of Money

When Paul Newman played "Fast Eddie" in The Hustler 1961 and reprised his role along with Tom Cruise in The Color of Money in 1986, the color reference to U.S. currency notes was the traditional green cloth of a pool table. Today's game is the race to invent and commercialize green technologies, or GreenTech.

Historians may debate the specific catalyst that led to the inflection point in America's mindset towards "going green." I think Al Gore may lay claim that his Oscar-winning film An Inconvenient Truth, brought the collective consciousness of our nation forward on issues of global warming, carbon footprints, and conservation. As he is no longer running for public office, hopefully his Nobel Prize won't be as misrepresented and maligned by politicians and the press as his poorly worded statement in an interview with Wolf Blitzer in 1999 that "during my service in the United States Congress, I took the initiative in creating the Internet." Of course, he never meant to imply that he "invented" the Internet. I'll bet you have never seen reported the statement from Vincent Cerf (who is commonly referred to as the Father of the Internet) that "the Internet would not be where it is in the United States without the strong support given to it and related research areas by the Vice President in his current role and in his earlier role as Senator." But I digress...

GreenTech is now the hottest ticket in VC, as investors quest for the next "killer app" since Al Gore invented the Internet (oops, there I go piling on!) The term GreenTech refers to all innovations in energy and environmental technologies. Although investors can point to very few IPOs or other liquidity events, this space is expected to result in billions of dollars in value creation for new ventures. As with any Gold Rush, there will be snake-oil salesmen and profiteers at work; nevertheless, I believe that fortunes will be made in the process of saving our small planet.

The Hitchhiker's Guide to the Galaxy... or to VCs

If you feel a bit like Arthur Dent in a bathrobe traveling through an unfamiliar and illogical universe in your quest for venture capital, there is now an interesting guide. While far from a perfect resource, TheFunded.com provides a voyeuristic experience into how specific venture capitalists have treated entrepreneurs, both good and bad. Members of TheFunded.com (including your's truly) post details about their experience pitching and working with particular venture firms and individuals. Of course, the quality of individual opinions is a matter of debate (particularly amongst venture capitalists); however, you can learn a lot from reading these postings. It's also a good resource to build a list of potential VC investors that are active in your space. Sadly, I have not found a posting from Deep Thought yet with "The Answer to Life, the Universe, and Everything."

My goal...

Those of us who are crazy enough to start a business know that there is only so much you can learn about entrepreneurship without experiencing the challenges first-hand. Does this mean that you should not prepare yourself to face these challenges? Can you not learn from others' successes and failures? Of course not!

As arguably the greatest American inventor and statesman, Ben Franklin penned many famous sayings, including "an investment in knowledge pays the best interest." This will not be the last time I refer to BF, because as a great entrepreneur in so many fields and professions throughout his lifetime and as possibly the first rags to riches exemplar of the American Dream, his copious writings provide us with a treasure trove of wisdom from a man who was fantastically successful at so many endeavors.

The purpose of my weblog, however, is not to emulate Poor Richard's Almanack. My goal is to provide my perspective on the contemporary challenges of entrepreneurship, which I hope will be of practical use to others. So, if you are:

• wondering whether to pitch your start-up to an angel network;
• curious about opportunities during a housing market correction;
• puzzled by definitions and uses of founders stock, preferred equity, venture debt, mezzanine debt, senior debt, and factoring;
• wondering when to use a PR firm, hire a VP of marketing, use an outsourced call center, start an ESOP, or make a personal guarantee;
  
• looking for insight into trends in Cleantech, Social Networking, and Venture Capital;

then I hope you find reading my weblog a useful investment of your time.