A VC

Valuation and Option Pool

One of the more contentious things in the negotiation between an entrepreneur and a VC over a financing, particularly an early stage financing, is the inclusion of an option pool in the pre-money valuation. As my friend Mark Pincus likes to say, "it's just another way to lower the price".

I'll accept that critique. And take it one step further. The option pool is absolutely a piece of the price negotiation. But it is a very important one as I'll explain.

But first, let me lay out a few things for those who aren't well versed in these matters. The pre-money valuation is the value of the company before the money comes in. Let's say we call it $4mm. And let's say the financing is $1mm. Then the post-money valuation is $5mm and the $1mm round is 20% dilutive ($1mm/$5mm).

But to the entrepreneur it might be a lot more dilutive due to the inclusion of the option pool in the pre-money valuation. Let's say that the VC's term sheet says that a 15% "fully diluted post money" option pool needs to be in the pre-money valuation. What that means is that the investor wants 15% of the company, after the financing is closed, to be in an option pool that has not been granted to anyone.

In the case of the $5mm post money valuation, that means there needs to be $750,000 worth of options in the pre-money valuation. If the pre-money valuation is $4mm, then that means the true pre-money valuation to the entreprenuer is $3.25mm. And therein lies Mark's critique that the option pool is just another way to lower the price.

I am sure I lost a few of you on all of that math. If you want to drill down on it, please leave a comment and we'll help you figure this out. It is very important you understand all of this if you are or want to be an entrepreneur who raises venture capital.

The bottom line is the deal I described leaves the entrepreneur and his/her shareholders with 65% of the company after the financing, the VC investor will own 20%, and there will be an option pool representing 15% of the company that has not been issued yet. The $1mm financing was not 20% dilutive, it was 35% dilutive.

So it is not surprising that entrepreneurs hate this provision and fight about it every time. And like most terms, VCs have been abusing it for years by asking for excessive option pools making the provision hated more than it needs to be.

The first point I'll make is that VCs should be upfront about this provision and the fact that it is simply about price. In the example above, I'd be happy to pay $3.25mm pre-money with no option pool. Or I'll pay $4mm pre-money with one. They are the same thing to me. What an entrepreneur needs to do is find out what the market price for their company is with and without an option pool in the number. Once they do that, the negotiation over this point is a lot less contentious.

The second point I'll make is that the option pool request needs to be reasonable and based on some kind of budget. I generally ask the entrepreneur to put enough options into the "pre-money pool" to fund the hiring and retention needs of the company until the next financing. My thinking on this is that I don't want to get diluted between financings. So I like to see a headcount based hiring plan with expected options against each hire combined with a retention plan for all current employees who will need additional option grants.

In most of the early stage financings I've done in the past few years this work on the option pool has shown a need for around 10% in unissued options. I've seen it as big as 15% but that is rare. I've also seen it as low as 5%, but that is even more rare. But the point is this; don't guess or negotiate this number. Do the work, figure it out, and put it in the pre-money and then negotiate price.

I'll wrap with a true story about this provision. When Mark and I were negotiating the first round of financing for Zynga, we got into a real tussle about this provision. He did not want an option pool in the pre-money valuation. I did. Once we agreed that it was just a fight about price, the conversation got easier. I got him to give me an estimate of the pool he would need. We added it to the valuation we had agreed to. He got an increase in price, I got an option pool. And I got one of the best investments I've ever made.

Comments (View) | Posted November 6, 2009 in Venture Capital and Technology

Great Meetup Last Night

About a hundred readers of this blog gathered last night in the cafeteria of Washington Irving High School just off of Union Square in Manhattan to meet each other and celebrate the generosity of this community in the recent Donors Choose Bloggers Challenge.

It was a great moment for me. I got to meet many readers who I know by name but not in person. Putting a face to a name is a wonderful thing. I also got to meet Sarah Bunting, whose blog, Tomato Nation, raised $315,000 for Donors Choose in October. Talk about "blog stars". I've got a lot to learn from Sarah.

And I got to meet a bunch of teachers. One woman teaches middle schoolers in the Bronx with special needs. A couple others teach music in a middle school in southern brooklyn. A third teaches pre-K in the East Village. I met several others as well. 

I am telling you that these people (all women) are doing god's work. And it made my day to meet them and know that we all did something to help them.

It may have been the first meetup I've done with all of you, but it won't be the last. Thanks to everyone who showed up. I know we were competing with the Yankees but I got home in time to see them put the Phils away and I suspect most everyone else did too.

Comments (View) | Posted November 5, 2009 in Venture Capital and Technology , Weblogs

Throw The Bums Out

I drove out to the middle of New Jersey yesterday morning to attend a board meeting. Everywhere I went, I saw "dump corzine" messages. It was clear the governor was in trouble.

And this morning, we wake up to the news that Corzine has indeed been dumped and Mayor Bloomberg barely got 50% of the voters in NYC to pull the lever for him

Both of these men are wealthy. Both of these men grew up on wall street in the 1970s. Both of these men moved from wall street to public service about a decade ago. Both of these men spent heavily to get re-elected. Bloomberg made it, Corzine did not.

It's worth spending a minute thinking about the message the voters sent here in one of the most liberal parts of the country. The voters aren't happy. The voters aren't comfortable with rich guys who can spend their personal fortunes getting elected. And most of all, the voters want change.

This may well be a referendum on Obama, but I see it more as a referendum on the status quo. It's a throw the bums out moment in this country. It's too bad that Nancy Pelosi, Harry Reid, Barney Frank, Chris Dodd, Mitch McConnell, and John Boehner didn't run for re-election yesterday. Maybe they would have been sent home as well.

It is not a positive to be an incumbent right now. And that's a good thing because the track record of our government sucks. I hope the anti incumbent mood continues to be honest. We could use a good house cleaning throughout our government.

Comments (View) | Posted November 4, 2009 in Politics

The Double Opt-In Introduction

I'm sure everyone out there gets email intros. Someone who knows you sends you and someone you don't know an email suggesting you meet.

I send emails like that a lot. I might send a half a dozen or more every day.

I get even more emails like that. Sometimes dozens a day.

And I'd like to propose some email intro etiquette which I follow almost religiously myself:

When introducing two people who don't know each other, ask each of them to opt-in to the introduction before making it.

Last night I got talking about this with some friends who also get a lot of email intros. All of us get email intros that we don't want to follow up on. Some just ignore them. Others reply with something like "I'm really busy now and will get back to you in a month." And then never do.

I don't really like either of those two solutions and I also don't like responding to an introduction email with something like "I'm sorry but I don't really want to meet you".

So I often take meetings in these situations that I don't really want to take. And that means I'm less available to meet with people I do want to meet.

My friends said that I should simply keep track of who is giving me bad intros and let them know about it. I'm sure that I should be doing that and probably am at some level.

But I think asking for permission to make an email intro before making it is good form. I try to do it as a matter of practice. And I wish more people would.

Comments (View) | Posted November 3, 2009 in Venture Capital and Technology

Thematic vs Thesis Driven Investing

As the venture business has grown and matured, many firms have developed specific areas of focus. Our firm, Union Square Ventures, for example only invests in web services. I believe this is a good thing for both the investors in venture funds, called LPs, and the entrepreneurs.

But there are a number of ways that firms can execute their focus on a particular area. Two of the most popular are "thematic investing" and "thesis driven investing".

They are very different.

Thematic investing involves identifying big themes and going after them. Examples from the world of web services would be "social networking", "online video", "ad networks", "social media", "real time", "mobile". I know many VCs who go about it this way. They identify the themes and then get busy filling out their portfolio with companies that fit those themes.

Thesis driven investing involves drawing a picture of where your particular area of focus is going. I like to take a five to ten year view. And once you have mapped out that picture, it becomes your thesis. And you evaluate every investment you make in the context of that thesis.

The two venture firms I've been involved in founding are good examples of these two approaches. Flatiron Partners was largely a thematic oriented firm. We identified the web as a big theme and within it we identified content, commerce, and community. And we made big bets in those themes. It worked out pretty well but we didn't see the web changing at the end of the decade as much as we should have.

Union Square Ventures is a thesis driven firm. I owe that to my founding partner, Brad Burnham, who has the discipline to force everyone to do the work to develop our thesis and the discipline to make sure we put each and every investment through the thesis test.

Just last week, we were meeting with one of our LPs and I was talking about the mobile web in that meeting. Later that afternoon, Brad walked into my office and put our thesis on web vs mobile web on the table and we made sure we were seeing the mobile sector play out the same way. An important factor in thesis driven investing is everyone in the firm needs to buy into the thesis or it won't work.

Thematic investing is good for bigger firms. It allows each partner to pick a couple themes and go after them. Thesis driven investing is good for smaller firms. It requires a tight team that works to keep themselves on the same page executing after a singular vision.

I believe thesis driven investing produces the best returns when the thesis is directionally correct and probably also the worst returns when the thesis is wrong. I believe thematic investing works less well because it can lead to "bucket filling" where the firm just runs around filling the themes with deals without much thought to why and how they will work. It also leads to a lot of "me too" investing which is a scourge that the venture industry can't seem to figure out how to rid itself of.

But both thematic investing and thesis driven investing are better than a generalist approach because they both promote domain expertise which is critical to building a sustainable investment advantage. I think "generalist" or "opportunistic" investing is likely to underperform domain expert driven investing in all but the most turbulent markets.

It would be good to talk more about how one goes about building a five to ten year map of where an industry is headed. That's a longer conversation than I have time for this morning. But I'll leave you with the thought that this blog is a part of how I build mine.

Comments (View) | Posted November 2, 2009 in Venture Capital and Technology

The Donors Choose Threepeat Is Complete

We did it, for the third year in a row, this blog has won the tech blog category of the donors choose blogger challenge. Most importantly, we raised a total of $37,504 for teachers' projects in public schools. That number includes a $19,680 match from HP. Backing that out, this community contributed a total of $17,824 this year.

Here's our three year history:

It is interesting to me that the total amount raised by this community has been relatively constant over the past three years but this year we really took up the level of participation.

That may be a result of the meetup I am doing this coming week on wednesday evening. The deal is anyone who gave to the donors choose campaign via my giving page is invited, irrespective of the size of the donation.

There are 115 people rsvp'd for the meetup which is almost equal to the increase in donors this year over last year. That tells me that the meetup strategy worked. I am looking forward to meeting all of you on wednesday evening.

I'd also like to point out that donors choose raised a total of $630,938 in the blogger/social media challenge. That number includes the $200,000 match from HP. Even without the match, Donors Choose was able to increase the giving from $270,000 to $430,000. Some of the big new categories were Twitter, led by Livia Stone's $18,422 and Craig Newmark's page which tallied $12,091.

But nobody can touch Sarah Bunting's Tomato Nation, which has dominated this whole campaign the past three years. This year, the Tomato Nation community pulled in $314,158. I believe Sarah will be at the meetup on wednesday. I'm dying to meet her as she has proven that blog communities can do amazing things.

In conclusion, I want to thank everyone for putting up with my non stop promoting of the donors choose bloggers challenge this month, and I especially want to thank everyone who contributed. It's a great cause and I'll bet that many of you will make additional donations when you see how amazing the follow up/thank you process is. Donors Choose is a fantastic public service and I'm really proud to be involved with it.

Comments (View) | Posted November 1, 2009 in Venture Capital and Technology

Two New Ways To Find A Better Place To Stay On The Road

My partner Albert said this a week or two ago on his blog:

When people ask me whether investing in web services is a long-term opportunity, I often say that “we ain’t seen nothing yet.”

I was reminded of that when I went to the web to find a hotel to stay in Miami when I am down there for Future Of Web Apps in February.

In the past, I'd have tried TripAdvisor or maybe even Google. But just in the past few months, there are two really great new ways to do this.

The first is Oyster, a web service dedicated to honest and excellent hotel reviews. They literally send out a person to stay in the hotel for a few days, take their own undoctored photos, and present in a clear and concise format. Here's their page on Miami hotels, and here's a page on Tides in South Beach, which they say has awesome rooms.

Oyster's strength, personally crafted reviews, is also its weakness because they only have reviews right now for certain destinations. I suspect it will take them a few years to be totally comprehensive. However, because so much hotel seeking traffic comes from Google, they can be a great service for people who start their hotel searches at Google. If you see an Oyster result in Google, you should absolutely click on it.

The other way to do it is Hunch. Instead of hiring "experts" to go out and review the hotels, Hunch takes an approach that is more like wikipedia. They crowdsource questions and answers from thousands of "contributors" and then package them up in easy question and answer sessions that lead you to the "right answer".

Try this hotels in miami page and see how it works. You'll notice that Hunch doesn't give you just one answer. It gives you a "best" answer and three other suggestions. I've found that not only do I get good advice from Hunch, it also helps me quickly understand the tradeoffs I am making in hotel decisions.

Of course, there's a natural partnership between Hunch and Oyster around hotels. Hunch is good at framing the decision and giving you a short list to consider. Oyster is great for digging into the specifics of the hotel to get to the final choice.

Since both companies are in NYC and are part of the great startup culture we've got going here, I bet that's not too hard to make happen.

Comments (View) | Posted October 31, 2009 in Blogging On The Road , Web/Tech

Slow Capital

Last friday my partner Brad attended a company offsite for our portfolio company Meetup.com. On monday of this week during our regular weekly meeting, he gave our firm (all five of us) a report on the day which he said was excellent. One thing that stuck in my mind all week was his description of the lunch talk by one of the leaders of the "slow movement" (whose name escapes me now).

I'm familiar with the slow food movement and I would say that our family, led by the Gotham Gal, are active participants in it. I'm less familiar with the broader slow movement. This quote from Guttorm Fløistad via Wikipedia explains:

The only thing for certain is that everything changes. The rate of change increases. If you want to hang on you better speed up. That is the message of today. It could however be useful to remind everyone that our basic needs never change. The need to be seen and appreciated! It is the need to belong. The need for nearness and care, and for a little love! This is given only through slowness in human relations. In order to master changes, we have to recover slowness, reflection and togetherness. There we will find real renewal.

There are now sub-movements like slow travel, slow parenting, slow art, slow sex, etc. All of them promote the idea that we should slow down, relax, and take our time at things instead of "getting it done and moving on".

I'm not much for any orthodoxy but I do appreciate the sentiment behind the slow movement and I've been thinking all week about what "slow capital" would be. And of course, I believe that Union Square Ventures practices slow capital. Here are some basic tenets of slow capital:

1) doesn't rush to conclusions and doesn't expect entrepreneurs to do so either

2) flows into a company based on the company's needs, not the investor's needs

3) starts small and grows with the company as it grows

4) has no set timetable for getting liquid: slow capital is patient capital

5) takes the time to understand the company and the people who make it up

I've spent almost twenty five years in the capital markets watching investors behave. Way too often it is a "wham bam" experience and then off to the next deal. Things like exploding offers, "fly by" board members, and shotgun marriages are so common that you sometimes wonder how anyone makes any money.

There's a reason why Warren Buffet is the best investor of his generation. He practices slow capital and I am proud to say that our firm does as well.

Comments (View) | Posted October 30, 2009 in Venture Capital and Technology

"Audio Preview" Is A Bad User Experience

I read the Google blog post announcing their enhancements to music searches this morning. I think it's terrific that Google has made these enhancements but there's one thing I don't like.

Google says:

Now, when you enter a music-related query — like the name of a song, artist or album — your search results will include links to an audio preview of those songs provided by our music search partners MySpace (which just acquired iLike) or Lala. When you click the result you'll be able to listen to an audio preview of the song directly from one of those partners. For example, if I search for [21st century breakdown], the first results provide links to songs from Green Day's new album. MySpace and Lala also provide links to purchase the full song.

I really dislike the "audio preview" experience. It's been available for years in the iTunes store and I never use it. A 30 second sample of a song is an awful experience in my opinion.

When I want to search for music, I'll do an mp3 search on the Internet or go to the hype machine and do the search there. I almost always get the result I want with one of those two approaches and I can listen to the entire song.

Of course, it is not Google's fault that they are being limited to an "audio preview", it is the fault of the rights holders who won't let Google offer a full song sample. But as we've seen again and again, this only drives users to the "gray market" where they can get a full song sample which is often just a right click away from an illegal download.

A smarter approach would be to allow Google to offer a full song sample (one play per person based on cookies or some other approach) and then a link to purchase. That would allow Google and the music rights holders to take share back from mp3 search engines and encourage music purchases instead of illegal music downloads.

Comments (View) | Posted October 29, 2009 in My Music , Web/Tech

Swinging For The Fences

There has been a lot of talk about young entrepreneurs creating all the great companies; Gates, Jobs, Yang/Filo, Bezos, Dell, Brin/Page, Zuckerberg, etc, etc.

I agree that visionary young people are worth backing and we do a lot of that at Union Square Ventures.

But there is another kind of entrepreneur I love backing even more. It's the serial entrepreneur who has had a number of successes under their belt and now wants to swing for the fences. We have a bunch of them in our portfolio and there is nothing more fun than watching someone who has a ton of experience get behind the wheel and really step on the gas.

When someone has two or three startups under their belt, they understand a bunch of things that a first time entrepreneur doesn't. They understand the value of setting a very clear vision and getting everyone on that page. They understand that they need to hire the very best people. They understand how to raise capital and pick their investors carefully. They understand how to make quick decisions and not let issues fester. They have a rolodex of talented people and potential business partners they can get on the phone or email quickly when they need them. Most of all, they ooze confidence and make everyone better around them.

These entrepreneurs usually have enough money in the bank that they are not looking for a payday. They don't build their companies to flip. They build their companies to go all the way. They are doing it for money, but they are also doing it for the thrill of the game, for ego, and to build a legacy. Those are very powerful motivators, much more powerful than money if you ask me.

If you look at our portfolio, you'll see quite a few startups created by young visionaries and quite a few startups created by serial entrepreneurs who are swinging for the fences. There isn't much else to be honest.

We are open to all kinds of entrepreneurs and we don't screen for age or track record. If you have built a web service that fits into our investment thesis, you'll get a hearing at our firm regardless of who you are and what you have done. But it is also true that we tend to back young visionary founders and successful serial entrepreneurs most of the time. That's because we've made a lot of money doing those two things and not so much doing anything else.

Comments (View) | Posted October 28, 2009 in Venture Capital and Technology