Archive | May, 2008

The Rise of the Pledge Fund

19 May

Angel investing has existed since the very beginning of what we consider the modern age of venture capital. Indeed, long before there ever was much of a venture capital community, loose groups of semi-retired execs assembled regularly to discuss interesting young technology companies to fund. Routinely, there would be a “passing of the hat,”  some cursory discussion of deal terms and, whammo, a seed investment would be made. Colorful stories of just such seat-of-the-pants financings of companies that later became tech industry juggernauts are now the stuff of venture capital legend.

Since the “institutionalization” of venture capital, beginning in the 1970s, angel investing has evolved quite dramatically. Sure, there will always be wealthy uncles and trusting friends willing to back energetic young entrepreneurs with intriguing business ideas, but finding strangers willing to do so out of their own pocket has become increasingly challenging. Indications are that it will become only more difficult as many “angels” have found themselves squeezed out of many opportunities and the prospect of backing companies in general increasingly fraught with risk and uncertainty.

To be sure, true angel investing is tough to do – and even tougher to do well.  For this reason, even many successful retired venture capitalists steer clear of angel deals. The reasons for this are many. For one thing, it is not often that an investment comes along that matches one’s direct domain expertise, skillset, and network of contacts. As such, many angels get into the dicey business of investing out of one’s comfort zone and away from a relevant knowledge base that can actually help the company. This is fine when things are going well, but when things hit rough patches many angels find themselves unable to really be of much assistance. This can be enormously frustrating for both the angel investor and the company experiencing troubles and needing sound guidance from its investors.

But this is just the tip of the iceberg when it comes to the challenges of being a good, successful angel investor. For every Andy Bechtolsheim or Ron Conway there are a thousand well-meaning angels who made their money in shopping centers or tanning salons only to lose a chunk of it backing technology or life sciences ventures where they had no expertise or understanding of what was really going on at the companies.

However, even with the risks, prospective angels understand that participating in early stage deals can bring staggering rewards for those fortunate enough to come in on the next Google, Skype or YouTube. And thank goodness for that, because angels provide a critical and increasingly valuable service to the venture and start-up community. As venture capital fund sizes have generally increased in recent years, many venture firms have moved upstream into more developed opportunities where more capital can be deployed and where the classic early stage risks can be somewhat mitigated. The result of this has been a dwindling universe of investors that still specialize in truly raw, early stage opportunities. 

For years, the options available to individual investors determined to participate in venture were not terribly attractive. Option one: Become a limited partner (LP) in a top-performing venture capital fund. Sounds good, but in truth many venture funds have increased their average fund sizes dramatically in recent years and, as a consequence, have focused almost exclusively on big institutional investors (endowments, pension funds, etc) to make up their LP base. In many cases, individual investors need not apply — unless, of course, you were in that particular VC firm’s last few funds and have an established relationship with the partnership. Secondly, the need for a venture capital firm to openly solicit funds outside a narrow group of previous limited partners is proportionate to an extent with how successful it has been historically. In short, the more successful and renown the firm the less it probably requires or wants your investment commitment (again, unless you are already a known quantity with that fund and there is a relationship already.)

Option two: Become an angel investor. For reasons cited earlier, this is tough. Even with a technical background and some operating or investing experience, how does a prospective angel begin to create deal flow? How will entrepreneurs of promising companies even find the angel or learn that he or she is interested in making early stage investments? Of course, the prospective angel can try to join a prominent angel fund to gain access to their deal flow, but such groups are often very exclusive, require one to go through a lengthy and competitive membership process that can take months, and are often closed to new members for years at a time.

Now, fortunately, something of a third option which can mitigate some of the inherent risks in angel investing has begun to emerge. Enter the Pledge Fund.

What is a Pledge Fund?

A Pledge Fund is essentially a non-committed venture capital fund, or a fundless VC firm if you will, that operates as a bit of a cross between a traditional venture firm and a loose confederation of individual angels making early stage investments together. The logic is fairly simple: take the best elements of both structures to create a model that enables individual parties to make angel investments in a standardized, formalized way that eliminates many of the traditional pitfalls of angel investing on one’s own.

How it works:

The Pledge Fund is typically run by experienced angels or former (or even current) VCs. These individuals constitute the “GPs”, as it were, of the fund. The GPs handle all of the admin functions of the fund much as one would expect at a traditional venture firm: outreach to the entrepreneurial community; sourcing, vetting and presenting deals to the Pledge Fund’s “investors” (often called “Members” — more on that later); handling term sheet negotiations; drafting documents; and handling post-investment support by means of sitting on company boards, etc.

This GP management layer, if you will, is critical because individual angels are just not set up to handle most of these functions. Even assuming an individual angel can find good deals (and that’s a big assumption), will that person even be able to properly evaluate it? Will he recognize the flaws? Can he properly size up the team and do thorough due diligence on the technology? on the market? Would he have access to broad groups of experts in various fields to help him vett the opportunity and the management team? Even after an investment is made, will the angel sit on the company’s board and, if so, can he really expect to make much of a contribution?

A good venture firm performs most, if not all, of these management, deal-making, and post-deal support functions. So, in a sense, a Pledge Fund does much the same thing on behalf of the angels. The key difference is that, unlike in a traditional venture fund, the Pledge Fund does not operate a blind pool of capital from which to invest in deals. The Pledge Fund can only source, vett, and scrub deals for its members. It is the members that ultimately determine what deals they participate in. Traditional venture capital firms, by contrast, typically offer their limited partners little to no say in what deals the fund invests in and in overall day-to-day firm operations.

On becoming a Member:

Most Pledge Funds have a straightforward process to gain admission to the organization. There are usually some questionnaires to complete and accreditation requirements to meet, but they are far less onerous than one would expect at many venture funds. Once admitted as a Member, the only commitment is a small annual management fee (usually to cover overhead and ancillary fund expenses) We’ve heard management fees in the $5k-$10k/year range. The thinking behind the fee is not so much to be a revenue generator as much as a way to cover basic costs and to weed out people who are not serious about actually making seed stage investments. The logic goes that if a prospective angel is considering $100k-250k in angel investments over the next couple years, paying $5-10k a year to see scrubbed and vetted deals should not present an issue; if it does, then the investor was probably not serious to begin with.

This management fee permits the Member to gain access to the Pledge Fund’s deal flow but does not commit him in any other way. Each month, the Pledge Fund’s deal review committee scrubs all that month’s deal submissions, meets with the most promising companies, conducts a preliminary due diligence process, and selects the top 3-5 deals. Those deals are then scrubbed again, executive summaries in the Pledge Fund’s standardized format are prepared, and the deals are submitted to the Members.

Members are then given a fairly narrow window (we’ve heard a few days, some as long as a week) to review the deal submissions and respond back to the Pledge Fund GPs about which deals, if any, they are most interested in. In short order, the Pledge Fund GPs can determine what syndicate, if any, they can pull together among their Members to make an investment.  If it can, then deeper diligence is commenced, the Pledge Fund’s attorneys are summoned to draft deal documents, and things move apace at that point.

Once an investment is made, another interesting twist occurs. In the past, angel deals sometimes suffered from a bit of a stigma within the venture community. Venture investors looking at an investment that was previously seeded by angels sometimes grew concerned that they might be inheriting unsophisticated investors on the board and/or otherwise involved with the company that could potentially cause problems down the road. Stories of neophyte “friends and family” investors throwing up roadblocks or being obstructionist when a professional investor got involved are fairly common in the venture community. For this reason, some venture investors are leery of angel deals unless the angel group is already well-known and respected within the venture community.

To get around this problem most Pledge Funds structure the investment by creating a separate limited partnership entity to make the investment into that specific company. The Pledge Fund’s Members are then LPs in that new entity that, in turn, makes the actual investment. The impact of this is two-fold: (1) for the purposes of the Capitalization Table, there will not be a list of every Tom, Dick and Harry angel investor and their individual investments; there will only be a listing of the Pledge Fund’s name and the name/number of the LP — i.e. Acme Pledge Partners, Fund I, etc. That keeps the Cap Table pretty clean; (2) If a board seat is part of the investment terms, then a member of the Pledge Fund’s GP group will take that board seat. Since the Pledge Fund’s GP group is often made up of former VCs or well-known angels, there is less concern from professional investors that the member representing the angels will be unsophisticated and/or obstructionist.

Obviously, it’s still early days for this new form of Pledge Fund and it will be some time yet before we can opine on whether this model will become commonplace in the venture community. That said, we have seen versions of this in the past and always found it intriguing for the reasons cited here. It appears that, at least in this current iteration, this modern Pledge Fund approach is presenting a well-constructed and well-reasoned model for those individuals interested in early stage investing while mitigating many of the classic pitfalls long associated with the practice.

[Updated Note: In light of the response to this post, readers interested in learning more about Pledge Funds and/or interested in being put in touch with funds pursuing this strategy are asked to contact me directly at jtower(at)citroncapital(dot)com for more information.]


ABC – Always Be Closing!

15 May

David Mamet fans will recognize the title from one of the more memorable lines in Alec Baldwin’s “pep talk” speech to a slumping sales team in Glengarry Glen Ross. I bring this up in the wake of sitting through back to back pitches this week where companies failed to make evident what was being sought from the discussion. As Fred Wilson discussed in his recent post on the subject, it is critical for start-up teams to, for lack of a better term, ‘ask for the order.’

Asking for the order simply means laying out for investors what you are asking of them. One would be surprised at how many flashy, full-color presentations a venture investor receives in a given week where what is being sought is not made clear in the materials. Countless hours are invested by a management team in a good set of investor documents. In many cases, a full set of integrated financial statements, an exhaustive analysis of the competitive landscape, and projections so detailed that the itemization of the number of staplers for the admin pool in the year 2011 is provided. Unfortunately, what is often omitted in all this superfluous detail is how much in funding the company is seeking, in what form, and how those funds will be allocated.

Every 8th grader remembers the building blocks of English Composition. Every course inevitably presented a maxim that, broadly speaking, went something like this: Tell them what you’re going to tell them; tell them; then tell them what you’ve just told them. Tangential to this maxim was the part in every good term paper that was referred to as the ‘Call to Action.’ What is it, dear author, that you are requiring of your reader? What are you asking of them?

These same principles, although admittedly a bit broad and simplistic, still apply in a general sense to a good investor presentation. Re-inventing the wheel is not necessary. Some of the best presentations I have ever seen were less than ten slides and had no whiz-bang graphics. Indeed, I have come to believe that longer presentations are not at all desireable unless there is a very specific reason when a longer presentation is necessary. Few companies meet that criteria.

So, in summation, I recommend that before start-up teams send off their documents or book a meeting with an investor, be sure that what is being sought is made abundantly clear in the documents.  Most likely, it took you a great deal of time and effort to get an all-hands meeting at that venture capital or angel fund. Don’t blow it – as they would say in the newspaper business —  by “burying the lead.” Put yourself in the place of a venture investor and ask yourself the following: How much are you seeking? How did you arrive at that number? What will that capital allow the company to accomplish? How far will it take the company? What are the milestones tied to that capital? [i.e. how will I, the investor, know that you have met your projections and objectives?]

Clearly, investors will have a great many more questions, but be sure that, at a minimum, the above questions are clearly addressed. Closing a round requires many elements too numerous to itemize and address in a single post. That said, no closing is likely to occur when the objective is vague and the path forward muddled and undefined.


More Musical Chairs on Sand Hill Road

9 May

Time was (and that time was not all that long ago) that the departure of a recognized general partner/managing director at a similarly recognized venture firm would be a buzzworthy 2-3 day story within venture circles.  Turn that “departure” tale into one where the departure involved that same investor joining a competitor firm and tongues would be wagging for some time.

In just the past few days, word has come out of the NVCA annual meeting that not one, but at least four, well-known and well-respected GP-level investors have left their respective firms to — in most cases — join a rival firm. If not unprecedented, this revelation certainly strains my memory to recall anything remotely similar in recent years. To be sure, partners retire. Other times, particularly when a firm has suffered poor returns or during a market downturn, partners are sometimes asked to, ahem, “make other career arrangements.” This is often so the firm can retrench or reposition itself; it can also just be because of a strategy shift or because there has been internal rancor in the partnership for some time and, as such, a decision was reached to make a change.  

Regardless of the particular circumstances, in virtually all cases there have been carefully planned transitions and sealed lips on where things went off the rails in these investor-partnership relationships. “Smiles and handshakes all around” is often the party line.

While I send my best wishes to all those investors who have recently moved to new firms, I do ask myself whether this is a harbinger of things to come in the industry. To state that many partnerships have been under strain in the past year is to state the obvious to anyone with regular dealings in this industry. Conventional thinking has long held that continuity is critical in investment partnerships. I think that belief is going to be strained. It is a truism that many limited partnerships, when considering an investment in a venture fund, look at the continuity and ties of the investment team. This is particularly the case when you are talking about venture funds that typically have a 10-year life. That said, with this spate of recent departures — and the community’s response to them by taking the news in stride, for the most part — one has to wonder whether we are entering a new period in the venture community where “moving across the street” from one firm to another much in the traditional style of investment bankers or corporate attorneys will become the norm in the venture community. I don’t have a crystal ball here, but I am anxious to hear other people’s viewpoint.

Microsoft walks away from Yahoo! deal

5 May

The deal that so many thought HAD to be done went belly-up in the wake of face-saving gestures and last-minute posturing. In the end, many analysts close to the 3-month drama are coming around to the idea that this was doomed to begin with. The Ballmer-Yang tango was simply too caught up in the always flammable combination of ego, desperation and klieg lights.  

AllThingsD’s Kara Swisher gets the nod for breaking the story and, if that was not enough, following up with a thoughtful, well-researched rundown of the tick-by-tick events, along with a good autopsy on where things really went off the rails here.

My preliminary take on it is that what ultimately killed this acquisition was a combination of puzzling strategic missteps (Ballmer), growing internal rancor at MSFT that began to pollute the combination, pride (Yang), and hubris and miscalculation (Yang and Ballmer). In the final analysis both parties were about $5 Billion away. That fact alone would not have (and should not have) tanked the deal. So, clearly, in the final analysis this was not about money. If Microsoft really wanted to move forward it would have countered Yang’s $37 figure and a medium would have been found, in my estimation. It chose not to do so because, in my view, by that time too much distrust and animus had crept into the water supply and things became irretrievably broken.

Both sides lost, in my view. Who ends up the bigger loser remains to be seen, of course. If Yahoo! CEO Yang wants to package this to his troops as some kind of victory, it is a Pyrrhic one at best.  Options for the company are still about as unpalatable as they were before this entanglement, perhaps even less so depending on what happens to YHOO stock next week. Some have opined that MSFT has $50 billion now burning a hole in its pocket, but acquisition targets are few and largely complicated in their own right. Some small properties might be acquired (Twitter? Digg?) but they will be, by and large, at the margins and not game-changing in any dramatic sense. A big move is what is required here, and there are not that many big moves left on the chessboard.

In any event, one oddity to come out of this all was Yang’s implication that Yahoo would embark upon a kind of ‘scorched earth’ policy in the event MSFT went hostile. That, in and of itself, is not unusual in M&A discussions of this magnitude. What was surprising, however, were the steps Yahoo! planned to take to muddy the waters so severely that MSFT would almost have to reject the transplant were the acquisition to proceed in a hostile fashion. The spitefulness of doing something that only makes sense so as to hurt another suitor was remarkable.

Reminds me of an old joke (with some modification for political correctness purposes) about a group of jungle explorers who are captured by cannibals. The cannibals bind the explorers and place them in a bubbling cauldron back at the campsite as young cannibals dance around them rejoicing. The cannibal chief approaches the explorers and informs them that they are to become dinner. The explorers’ skin will then be used to make canoes. The “good news”, says the chief, is that the explorers can choose how they wish to die. The first explorer, a Frenchman says, “I will take zee sword.” The chief hands him a sword. The Frenchman stands up and says, “Vive la France” and runs himself on the sword. The next explorer, a Brit, says “I will have the pistol.” The chief hands the Brit a pistol. The explorer stands up and says, “God Save the Queen,” and shoots himself dead. The third explorer, a New Yorker, says “I will take the fork.” Puzzled, the chief hands the explorer a fork. The explorer begins stabbing himself profusely with the fork, drawing copious amounts of blood and revolting all who are witnessing it. The chief says to the New Yorker, “why are you doing this?.” The explorer replies calmly in his thick Tony Soprano-esque accent, “So much for your f___ing canoe”.

Casual Car Friday

2 May

This is firmly in the Only-In-Silicon-Valley column and is strictly meant to be all in fun: A reporter at a well-recognized periodical called me recently to remark on the odd and disproportionate appearance of exotic and super luxury automobiles on Fridays in the Valley — particularly on and around Sand Hill Road. She wanted my venture perspective on it all. I told her I’d need to do some more in-depth research to get to the bottom of things. And, while I was on the subject would her newspaper push through a requisition order for a lease on a Ferrari 599, preferably Rosso Corso with Tan interior, so that I might better be able to infiltrate the herd unnoticed. The phone went dead. 

Seriously though, in what some folks are saying (tongue firmly in cheek) is a new rite of Spring in the tech world, the highways and byways of Silicon Valley seem bumper to bumper with sleek Italian and German machines on Fridays…and, typically, only on Fridays. What do fast-rising venture capitalists, successful entrepreneurs and senior tech executives drive to work Mondays through Thursdays, you ask? Toyota Priuses, Hybrid Ford Escapes and other fairly nondescript, often eco-friendly, econoboxes.

So, on this lazy and balmy spring afternoon, as you nip out of the office for that critical 3pm coffee reboot, scan the parking lot. If you are seeing more Rosso Corsa than red, more Exeter Blue than Blue, and more Titanium than Grey, you’ve got a Casual Car Friday office. Spring is definitely here. Pass the margaritas. Gran Centenario Anejo, rocks, no salt.

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